Valuation of intangibles for financial and tax purposes ... or EPS vs. the IRS.
Purchased assets will first be valued for financial purposes. If the corporate tax department later produces a contemporaneous documentation report designed to avoid penalties under section 6662(e) that is at variance with the financial valuations, either the SEC, the IRS, or both could find these dueling reports a fertile ground for unpleasant discussions with the company. When one of the authors was a young boy, his aunt gave him a sign that defined an expert as "one who knew more and more about less and less." Companies that make acquisitions of targets with valuable intangibles can be placed at risk if the company hires experts whose focus has narrowed to the point where they fail to realize that financial accounting valuations have tax effects and vice versa. The more narrow the outside expert's silo, the more dangerous that expert's advice can be.
The IRS, SEC, and Congress are all focusing more attention on areas where financial and tax accounting overlap. The latest tax shelter rules focus on transactions that produce sizable "book/tax" differences (i.e., transactions reported on Schedule M of Form 1120). Congressman Lloyd Doggett of Texas has introduced legislation, the Corporate Accountability Tax Gap Act of 2003 (H.R. 1556), that would require public companies to disclose and explain their book/tax differences. In the near term, the focus on such crossover issues can only increase. The purpose of this article is to cast light on the competing forces at work in valuations, rather than to divine the "correct" answer.
"All generalizations are incorrect...."
The market capitalization of the average company on the New York Stock Exchange is five times the value of the book assets. The major factor that causes market value to exceed book value is the presence of intangibles, not irrational exuberance.
Nearly all types of intangibles leave only a fleeting mark on the financial records of most companies. At one end of the business spectrum, Microsoft's obvious intangible assets cannot be found on the Microsoft balance sheet. These assets were created by costs like R&D or advertising that have been expensed rather than capitalized, leaving no trace on the reported financials. In addition, the cost of an asset does not necessarily bear any relationship to its value. At the other end of the business spectrum, there is at least one entertainment company that has assigned no value to the multi-release recording contract of an artist whose last release sold more than 25 million units worldwide. This variance in how different companies account differently for their intangibles is permissible under Generally Accepted Accounting Principles (GAAP) because the U.S. Financial Accounting Standards Board (FASB) does not require the valuation of self-developed intangibles.
In contrast, when a company purchases an intangible asset, or purchases a target company with intangible assets, an entirely different set of rules applies. FAS 141 mandated the end of "pooling" and requires that the purchase method of accounting be used. The purchasing company must assign a value to all of the tangible and intangible assets purchased and record these asset values on its balance sheet.
The value of the purchased intangible must be allocated between goodwill and the intangible assets other than goodwill. To be recognized as separate from goodwill, the intangible assets must stem from legal or contractual rights, or be capable of being separately sold or transferred. This value must then be entered on the acquirer's balance sheet. The dichotomy is that the Coca-Cola secret formula or trademark need have no entry on the company balance sheet, but if Coca-Cola were to purchase Snapple, it would have to record an entry for the Snapple trademark and formulas.
The Best Result: Financial Reporting
The purchase price is allocated first to cash and cash equivalents, then to inventory, and finally to other tangible assets. The "residual method" starts off by valuing the easiest assets, leaving the more judgmental valuations for latter in the process. Any value remaining after assigning value to the tangible assets is allocated to the intangible assets, then apportioned among the various classes of intangible assets. Intangible assets are clearly the most difficult to value. At this stage of the acquisition process, the financial advisers are in control and the U.S. tax advisers may not have yet been invited to participate. Tax concerns, however, should be raised at this juncture.
The key driver at work in the financial allocation of intangible value is that goodwill is no longer amortized under FAS 142. If an asset is classified as non-amortizable goodwill, it is not an expense that will reduce financial earnings or all-important ratios such as earnings-per-share (EPS). Earnings and EPS ratios often have a direct effect on the stock market's pricing of a company's stock, which in turn may impact on bonuses, options, and longevity. Values assigned to other tangible assets, like widgets, and intangible assets, like patents, can reduce future earnings.
If the entire purchase price could be allocated to goodwill (1), there would be no financial expense to reduce future earnings. Conversely, if all of the purchase price were allocated to the widgets in inventory, the income received from the sale of each widget would be reduced by the allocable portion of the purchase price allotted to each widget. Oversimplifying, if the $100 million purchase price was allocable entirely to goodwill, $50 million in widget sales would produce $50 million in profit. If the $100 million purchase price were allocable entirely to the widgets, the company would record a $50 million loss on the same $50 million of widget sales. When a company hires valuation experts for financial reporting purposes, there may be a bias to find a higher value in goodwill than in other tangible or intangible assets, since this will maximize reported future earnings.
The Best Result: Transfer Pricing
The taxpayer will be licensing some of the valuable intangibles that it has acquired from the target within its own intercompany group. This means that royalties may be flowing either into or out of the United States, depending on the situs of the intangible assets in the target group or the situs of the intangibles after the acquiring company has restructured the target. In any case, either the United States or some other tax jurisdiction will scrutinize these intercompany royalties to determine whether they satisfy the arm's-length standard as required by applicable IRS regulations and the rules of the Organisation of Economic Cooperation and Development.
The cornerstone of most tax jurisdictions enforcement efforts is the required contemporaneous documentation package. The IRS efforts in this area clearly make the U.S. a leader in respect of transfer pricing, but it is not alone. At last count, more than 30 countries require documentation and that number keeps growing. An acquirer, whether a U.S. multinational or a foreign controlled company (FCC), will probably find it prudent to document the value of the licensed intangible in order to show that it paid or received an arm's-length royalty from the license of the intangible. Non-U.S. jurisdictions may request the access to a U.S. pricing study and vice versa.
The licensed intangible will automatically be a long-lived intangible rather than goodwill. FAS 141 provides that intangible assets will be recognized (and valued) separately from goodwill only if they (1) stem from contractual or legal rights, or (2) can be sold or transferred. Since the intangible asset is licensed to an affiliate, it automatically has a value separate from goodwill. If the asset has a finite useful life, it must be amortized for financial reporting purposes.
In applying the U.S. transfer pricing regulations to the support the arm's-length royalty, valuation experts must assess whether there are any comparable licenses to unrelated parties or else they must use one of the comparable profits methods (CPM). One of the commonly used methods to determine the appropriate arm's-length license is the discounted cash flow method, which is also the preferred method for valuing intangible assets for financial accounting purposes. If the company wishes to defend a high royalty rate against attack by the tax authorities, it must find a high value in the underlying (non-goodwill) intangible.
Clearly there is no easy solution. One can only speculate whether senior management will be more interested in presenting higher earnings in the public financials or in avoiding a large tax assessment three years or so in the future. The more important issue is that the financial and tax valuations, if they are not identical, be reconcilable. Even if both employ a discounted cash flow technique, there will be differences.
The purpose of the tax allocation is to simply determine the fair market value (FMV) of the intangible asset. This is only an intermediate step in the financial valuation. In the case of purchase accounting, the valuation group must allocate a finite amount, the purchase price, to the assets. Stated differently, the amount allocable to all intangibles is the purchase price, less the amounts allocable to cash, cash equivalents, inventory, and other tangible assets. Any remaining balance of the amount paid must be allocated to all intangible assets on the basis of their underlying fair market values. The purchase price allocable to any individual asset may be at or below its FMV, depending on whether the purchase price was above or below the fair market value of the target. Any value remaining after allocating the purchase price to the FMV of the assets goes to goodwill. Thus, the value of any asset may be less but not more than its FMV.
Typical Fact Pattern
Assume the following fact pattern. Foreign parent with a U.S. subsidiary purchases a major U.S. operating company. The final purchase agreement has the foreign parent purchasing target's intangibles, such as trademarks and patents, leaving the U.S. subsidiary to operate a distributor/contract manufacturer. The U.S. subsidiary will have to license the trademarks and patents from its foreign parent to operate the target's business.
A value is assigned to target's plants and inventory, which increases the U.S. tax deductions and decreases the U.S. tax payable. Foreign parent places a high value on intangible goodwill and a low-value on the non-goodwill intangibles bought by foreign parent. This allows the acquiring company to keep the bulk of the value in goodwill, thereby maximizing post-acquisition earnings. Future royalties based on the transferred patents, however, will be measured against the low value assigned by the financial accountants.
Section 482 of the Internal Revenue Code requires that the payment for intangibles be arm's length and commensurate with income. These cross-border royalties can be subject to adjustment by the IRS if it finds that such payments, measured by the rules laid out under the section 482 regulations, were not the same as payments that the multinational would have charged unrelated parties. Unless protected by a contemporaneous study under section 6662(e), a 20-percent or 40-percent penalty could be tacked on to this adjustment.
Avoiding Dueling Valuations
If the tax and financial valuations are performed in different valuation silos by different groups of experts each focusing on their own specialty, the two groups may well produce differing valuations (designed to meet their differing goals), even if the same method is used. If the discounted cash flow method is used for both the financial and tax valuations, are the intangible assets being grouped in the same manner? Is the same discount rate being used? The same risk assumptions? Without coordination, there is a strong probability that the two groups will not use a consistent methodology, let alone arrive at a consistent valuation. Dueling valuations would severely damage the credibility of both valuations.
Whether a tax valuation that differs materially from a financial valuation could expose a company, in a post-Enron environment, to SEC or shareholder liability is beyond the scope of this article. Nevertheless, the authors believe it would be unwise for a company to tell the SEC to ignore the tax valuations, since the transfer pricing report was designed to support the company's tax treatment (which presumably minimizes the company's liability). Conversely, it would be imprudent to tell the IRS to wholly ignore a valuation prepared for financial reporting purposes (which, again presumably, maximized earnings). Indeed, the IRS might understandably have a greater degree of confidence in statements or calculations made for non-tax business purposes, than for those documents that were created for tax purposes. (2)
There is no easy solution to this tension between higher or lower valuations of certain assets on acquisitions. Forthrightly addressing these issues and reaching an internal consensus, however, will produce a better result for the company than blithely failing to address the competing concerns. In most companies, it will fall on the tax department to raise the issues of overlapping valuations. We have seen no evidence during our 25 years or more of practice that the SEC looked at tax valuations, and tax information is currently available to investors under only extremely rare circumstances. The Enron debacle has brought to public view disturbing tax documents that normally are never seen outside the company (other than by the IRS). It would not be unreasonable to assume that the SEC may make more requests for tax documentation in light of the financial income generated by certain tax-driven Enron transactions. (3)
The IRS does seem to have intensified its scrutiny of company financial records in respect of transfer-pricing transactions. Thus, IRS International Examiners are being encouraged to review financial valuations as part of their examination of a company's transfer prices. Indeed, since these same IRS agents have been taken to task for not requesting certain transfer pricing documentation, (4) it would not be unreasonable for the agents to prepare an information request relating to the valuation of the acquired intangibles and, then, to ask that tax department to explain any differences between the financial and tax valuations. It is better to anticipate and be prepared for such a request than to learn of the differences from an examining agent.
Additional Valuations. It is not unusual for companies looking to acquire a target to hire an investment adviser, and target companies that are "putting themselves on the block" also often hire an investment bank to help market itself. The target's investment bank begins by finding what the target owns and what the target is worth. Buyer's investment bank will identify potential targets based on criteria that include the target's assets and the cost for obtaining similar assets. The IRS Manual suggests that the agents may wish to request the investment banker report to determine how an outside expert determined a price range for the target and what value the investment banker put on the assets.
Such a report, coupled with the financial valuation of the assets, provides the IRS Agents with much relevant information. The IRS agents may not be familiar with the variations in the amount of detailed information in these investment banking reports. A client may be provided with only oral reports by the investment banker, even with respect to a multi-billion dollar purchase. Such a result, of course, may strain credulity, so the corporate tax department should work to know, upfront, what documents exist and then shape the IRS expectations with respect to documentation.
Those who have dealt with valuations know that there will always be differences among valuations, but these differences do not create problems if they are reconcilable. As a general matter, files should be purged of drafts containing inaccuracies and strategies that were not pursued. Care must be taken in respect of document retention and destruction policies and practices. The fact of the matter is that plans and pricing do often undergo significant changes during a transaction's planning and execution stages. It is best practice to document the course of the negotiations so that there is a paper trail that starts with the initial investment banker's report and ends with the final price.
It is probably best if the acquirer's legal department be charged with identifying all potential valuation documents and overseeing the destruction of documents not relating to the final agreement. Discussions of the fit between acquirer's and target's technology and marketing opportunities may cover confidential material. It may be advisable to hire outside counsel to make sure that procedures are in place to retain the attorney-client privilege, to the extent possible.
Location. One of the other interesting sidelights of the purchase accounting valuation is that it will also identify the corporate owner and the physical location of the intangible assets. It is obvious that the asset must be recorded on one corporation's books. Since companies are required by the SEC to geographically segment income, however, the physical location of an intangible asset must also be determined. Interestingly, there are times when the financial accounting rules will produce a different answer from that dictated by the tax rules. Financial accounting generally locates the intangible based on the legal ownership of the asset. The tax rules provide that beneficial or economic ownership resides in a company other than the one having legal ownership. If the parent company supplied the funds for the development of the intangible, then Parent owns the asset for tax purposes regardless of which affiliate holds legal title.
Impairment. Intangible assets, including goodwill, must be tested at least annually for "impairment," and if impaired, they must be written down, thereby shrinking overall assets and producing a book loss. If the FMV of the asset becomes less that the carrying value of the asset, a writedown will have to be taken. The notion of impairment is related to goodwill's no longer being amortizable. Does this mean that declining earnings demonstrate impairment, which requires a further asset writedown just when the numbers are turning bad? The answer is unclear.
Pursuant to Treas. Reg. [section] 1.482-4(4)(f)(2), transfer pricing rules require a similar annual revaluation of assets to determine the correct license fee for the current year. The tax review could revalue the intangible asset up or down; the financial valuation is only concerned with downward revisions of value. It would appear likely that the factors that would suggest that the value of a patent was impaired would also suggest that it would command a lower royalty. (5) Logically, the financial and tax reaction to bad news should be similar. It is entirely unclear if reducing the royalty because of a changed tax valuation requires a finding that the asset has been impaired.
There may well be reasons why financial and tax valuations diverge. In that case, it would be the prudent to perform an analysis of the two valuations that discusses why the assets were not similarly valued, i.e., because of differences in the financial and tax valuation rules.
A company can either maximize earnings or minimize tax, but not both, based on its valuation of acquired assets. Choices have to be made. It is clearly to the benefit of the tax department to surface these issues so that your company can make an informed choice. This is not an area where "ignorance is bliss"; rather, this falls more squarely into the "it's-what-you-don't-know-that'll-kill-you" category.
(1) Goodwill is the "residual," i.e., the value remaining after value has been ascribed to the other tangible and intangible assets; an increase in the value of goodwill requires that some other asset value is decreased.
(2) Courts ruling on tax matters have also found non-tax motivated documentation to have a higher probative value.
(3) Recent seminars given by a variety of organizations took the theme of "Making the Tax Department a Profit Center." Even though good tax planners have always kept an eye on the financial implications of tax recommendations, it does not seem the right moment to speak about creating financial profit in the tax department.
(4) Transfer Pricing Compliance Directive to LMSB Executives, Managers, and Agents from Larry Langdon, Commissioner LMSB (January 22, 2003).
(5) This seems to be proven by the converse; it seems difficult to imagine how an intangible could be impaired if its royalty increased or stayed the same.
BRIAN ANDREOLI and ED DEMBITZ are partners in Duane Morris LLP. Mr. Andreoli is a former member of Tax Executives Institute.
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|Title Annotation:||earnings per share|
|Date:||May 1, 2003|
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