IPEG
Any business professor will tell you that the value of companies has been shifting markedly from tangible assets, “bricks and mortar”, to intangible assets like intellectual property (IP) in recent years. IP in its various forms is increasingly used as the basis of many business and commercial transactions. It is fundamental for company valuations (merger, acquisition, bankruptcy); negotiations (selling or licensing); dispute resolution (fair recovery and quantification of damages); fundraising (bank loans and raising capital); assisting in decision making (corporate strategy); and reporting (tax and accounting).
Intangible Assets
An intangible asset is an asset that lacks physical substance and includes patents, copyrights, franchises, goodwill, and trademarks.
The International Accounting Standards Board standard 38 (IAS 38) defines an intangible asset as: “an identifiable non-monetary asset without physical substance.”
IAS 38 specifies the three critical attributes of an intangible asset to be …
- identifiability
- control (power to obtain benefits from the asset)
- future economic benefits (such as revenues or reduced future costs)
IAS 38 contains examples of intangible assets such as customer lists, copyright, patents and franchise agreements.
The Value and Valuation of Trade Secrets
The terms value and valuation and their cognates and compounds are used in a confused and confusing but widespread way in our contemporary culture, not only in economics and philosophy but also and especially in other social sciences and humanities. Their meaning was once relatively clear and their use limited. Value meant the worth of a thing, and valuation meant an estimate of its worth.
This blog will explore the subject of the valuation of one particular form of IP, namely trade secrets.Why trade secrets? Well, IAS 38 clearly indicates that a trade secret is also an example of an intangible asset, so long as it meets the three critical attributes – identifiability, control and future economic benefit. Trade secrets are a very important part of any IP portfolio. It is no exaggeration to say that virtually every business possesses trade secrets, regardless of whether the business is small, medium or large.
Trade secrets are an important, but oftentimes an invisible component of a company’s IP portfolio of assets. However, trade secrets can also be the crown jewels within the portfolio.
Why Conduct a Trade Secret Valuation
Before delving into the details of the valuation of a trade secret, it is important to appreciate that the rationale for conducting such a valuation may vary.
- For management information purposes
- For strategic planning
- For value reporting
- For accounting purposes
- For liquidation reasons
- To support a legal transaction
- For licensing
- For litigation support
- For dispute resolution
- For taxation planning and compliance
- For fundraising purposes
Transfer Pricing
Throughout this blog, one particular valuation rationale will be analyzed, namely transfer pricing. Transfer pricing is probably the most important issue in international corporate taxation. In taxation and accounting, transfer pricing refers to the rules and methods for pricing transactions between enterprises under common ownership or control.
A transfer price is the price at which members of a group transact with each other, such as the trade of goods and services between group members..
Transfer pricing also comes into play when the transaction between group members involves intangible assets and IP like trade secrets. In other words, transfer pricing is not limited to just tangible assets. Due to the rather broad the definition of intangibles for transfer pricing established by the OECD, the scope of the valuation as well as the resulting value will often differ from analyses performed for accounting and management information purposes; as stated in the OECD Guidelines (paragraph 6.7):
“Intangibles that are important to consider for transfer pricing purposes are not always recognized as intangible assets for accounting purposes. For example, costs associated with developing intangibles internally through expenditures such as research and development and advertising are sometimes expensed rather than capitalised for accounting purposes and the intangibles resulting from such expenditures therefore are not always reflected on the balance sheet. Such intangibles may nevertheless be used to generate significant economic value and may need to be considered for transfer pricing purposes”.
With trade secrets being a prominent example of Intangibles that are not being reflected on the balance sheet, but which may nevertheless generate significant economic value, it is evident that trade secrets cannot be disregarded for transfer pricing purposes. Trade secrets are explicitly recognized within the OECD Guidelines in Chapter VI Section A.4.2.
Tax practitioners which fail to identify relevant trade secrets as well as to develop a clear understanding of the attributable economic value face a high degree of uncertainty in respect to the question whether their transfer prices reflect an arm’s length compensation for the intangibles contributed by individual group members. Hence, with the growing importance of intangibles as the core value drivers within highly integrated value chains, understanding how to properly cope with intangibles and IP like trade secrets in transfer pricing is one of the key challenges faced by tax practitioners. Conducting a thorough stock-tracking analysis and compiling a respective analysis will be invaluable first steps to reduce uncertainty and risks.
The Requirements for Trade Secret Valuation
Conducting an IP valuation exercise requires transparent inputs, reliable and sufficient data, and objectivity of the person conducting the valuation. This applies also if the IP in question is a trade secret. Ideally, the valuation of the trade secret should have …
- Transparency – Qualification of the valuation inputs, assumptions, risks, sensitivity analysis, and disclosure
- Validity – Valid inputs and assumptions as of the value date.
- Reliability – If a valuation is repeated, it should reliably give a comparable and reconcilable result
- Sufficiency – The valuations should be based on sufficient data and analysis to form a reliable conclusion
- Objectivity – The appraiser should conduct the valuation free from any form of biased judgment
- Various financial and legal parameters – When performing a monetary IP valuation, various financial and legal parameters should be taken into account
From a transfer pricing perspective observing and documenting the above requirements will greatly contribute to the defensibility of the valuation. Tax practitioners need to be aware of in this context that tax authorities are extremely sensitive about the effects of information asymmetries. The basic assumption here, whether justified or not, is that tax authorities are generally at a disadvantage when assessing transactions involving intangibles. As a result, they will frequently second guess the valuations during tax audits. The recent discussion in the context of the BEPS point towards an increased (even reversed) burden of proof for taxpayers, as the OECD explicitly stated in the implementation guidance for hard-to-value-intangibles (BEPS Action 8, Public Discussion Draft, 23. May 2017) that:
“This guidance protects tax administrations from the negative effects of information asymmetry by ensuring that tax administrations can consider ex post outcomes as presumptive evidence about the appropriateness of the ex ante pricing arrangements. At the same time, the taxpayer has the possibility to rebut such presumptive evidence by demonstrating the reliability of the information supporting the pricing methodology adopted at the time the controlled transaction took place”.