Transfer pricing and valuation of intangibles

The transfer pricing issues facing international groups traditionally concern the terms and conditions of sale of a product or supply of a service. More and more often, they also concern the licensing of a trademark or a patent due to the paramount importance that these intangible assets have acquired in our economy.

Beyond the challenges that have traditionally been made with regard to royalties on the grounds that the company bearing them was loss-making or had incurred costs related to certain types of expenses that were presumed to be covered by the royalty, the GlaxoSmithKline case in the United States highlighted the increasingly sophisticated reasoning adopted by tax administrations. These administrations no longer hesitate to contest the remuneration for intangibles, in particular by questioning the intrinsic level of such amounts.

Accordingly, this raises the issue of substantiation of the amount of the royalties using a combination of the "tax" methods (based on the OECD Guidelines (OECD, 1995 Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations) pursuant to the arm's length principle) and the "financial" methods generally applied with regard to asset valuations.

From a financial standpoint, three types of methods are recognized for use in the valuation of an intangible asset: comparables methods, cost methods and revenue-generating methods.

Comparables (or multiples) methods: These methods consist in applying valuation multiples observed for recent transactions with regard to comparable assets to the specific financial data relating to the asset to be valued. Due to problems related to availability of the information and the non-reliability of this type of approach (problem of comparability, particularly with regard to a specific intangible such as a trademark), this type of method is generally not used, unless the specific circumstances prevailing on the market have made it the preferred method.

Cost methods: These methods consist in capitalizing the costs of developing and maintaining an intangible since its origin to determine a present value for such asset. Besides the problems relating to availability of the information (for example, the difficulty in identifying the development costs for a fairly old asset), the historical costs do not necessarily reflect the value of an intangible and do not therefore allow a fair assessment of its value.

Revenue-generating methods: These methods, known as "discounted cash flows" or "DCF" methods, consist in discounting to present value the future revenues relating to the intangible asset concerned. They allow for a more precise valuation of the assets inasmuch as they are based not only on forecasted financial information but also on market information. These methods are widely used nowadays to value intangible assets but require great rigor, in particular in the valuation of revenues (royalties paid for similar intangibles or residual profits attributable to the intangible).
To prove this rigor, a fair assessment must be made, in particular, of the anticipated level of revenues, namely the level of royalties received in respect of the intangible. This requires a determination to be made of the consistency of the remuneration from a tax standpoint in the light of the arm's length conditions resulting from the usual transfer pricing methods.

In its transfer pricing guidelines, the OECD recommends that particular attention be paid to setting prices for transactions between associated enterprises with regard to intangibles (Ibid, Chapter VI). More particularly, reference is made to the arm's length principle that sets prices between associated enterprises by comparison with uncontrolled prices.
With regard to the valuation of intangibles, the most appropriate transfer pricing methods recommended by the OECD, with which the financial methods can be used hand-in-hand under certain conditions, are the following two methods (It therefore appears that the Resale price and Cost Plus methods must be ruled out, except in very specific circumstances, as they only make it possible to make a combined valuation of the price of both the product and the intangible (without it being possible to identify the share attributable to each of its components). The same arguments lead to exclusion of the transactional net margin method):

The Comparable Uncontrolled Price ("CUP") method is to be preferred where a comparable transaction exists on the market.
This method is recommended by the OECD as being the most reliable inasmuch as it involves the most direct application of the arm's length principle. This CUP method is echoed by several of the financial methods set out above, for example the multiples method, but primarily in the application of the DCF method, where the royalty rate applicable is determined by direct reference to the licensing of comparable intangibles between independent enterprises.

The Profit Split method is recommended by the OECD for use in cases where other methods cannot be applied. It is moreover the preferred method when it is difficult to identify representative comparables on the market, as is often observed in the case of intangibles which are, by their very definition, differentiating factors for the enterprise.
The Profit Split method, which results from a complex analysis of transfer prices, is therefore of particular use in valuation of the cash flows related to the DCF method.
This method is based on the rationale that consolidated profit breaks down into two components (the "residual profit" method recommended by the OECD (Ibid, §3.5 p. III-3):
- Routine profit which is intended to remunerate the routine functions of the user of the intangible (the licensee). This routine profit is assessed on the basis of a search for independent enterprises that are comparable (in terms of products/services and functions);
- Residual profit representing remuneration for the "goodwill", i.e. the intangible assets (e.g. the trademarks or patents) but also the intrinsic elements involved in the company's performance (human resources, finance, control of its market, etc.). On these bases, it is necessary to separate out the portion of the residual profit related to the intangible which is assessed on the basis of a qualitative analysis of the importance of each of the other determining factors for the residual profit within the value chain.


In conclusion, from now on, it is important to base financial analyses for the valuation of intangibles on assumptions developed on the basis of tax principles that can be defended. The two approaches thus serve to corroborate each other, the financial approach due to the fact that it is based on secure assumptions and the fiscal approach as it adopts tried and tested economic and financial methods.