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© 2010 Ceteris. All Rights Reserved. Mark Bronson NABE Transfer Pricing Roundtable The Income Method: What are the Useful Lives of.

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Presentation on theme: "© 2010 Ceteris. All Rights Reserved. Mark Bronson NABE Transfer Pricing Roundtable The Income Method: What are the Useful Lives of."— Presentation transcript:

1 © 2010 Ceteris. All Rights Reserved. Mark Bronson NABE Transfer Pricing Roundtable The Income Method: What are the Useful Lives of Platform Contributions? June 24, 2010

2 What is Useful Life? Under § (g)(2) of the old cost sharing regulations, participants to cost-sharing arrangements had to make buy-in payments to owners of pre-existing intangible property that was made available to them for purposes of developing new intangibles. Taxpayer views of what was meant by pre-existing intangibles often did not agree with IRS views. - Taxpayers often attached value to pre-existing intangibles by assigning useful lives defined by the answer to the question If you no longer continued to invest in intangibles, how long would your current intangible stock be productive? - The IRS view seemed to be that the value of pre-existing intangibles included not only the value of intangibles as they existed at the buy-in date, but also the value of the rights to continue to invest in those intangibles. In application, this often took the form of income-method like valuations with high terminal values. New temporary cost sharing regulations put broader definition around non-routine contributions. The concept of pre-existing intangibles has been replaced by platform contributions. Platform contributions are defined as follows (in § T(c)(1)) : Any resource, capability or right that a controlled participant has developed, maintained, or acquired externally to the intangible development activity that is reasonably anticipated to contribute to developing cost shared intangibles. Under both the pre-existing intangible and platform contribution constructions of compensable contributions, the duration of useful life (or duration of anticipated contribution) is central to valuation. 2

3 What is Useful Life? The importance of useful life determinations is demonstrated in Judge Foleys opinion in the Veritas Software US Tax Court Case, where the buy-in valuation methodology used by the IRS expert was found to led to arbitrary and capricious determinations by the IRS in some part because Foley believed that the akin to a sale theory employed by the expert valued short-lived intangibles as if they had a perpetual life. Even the most expansive definition of compensable contribution needs to incorporate an understanding that no contribution lives forever. - Barriers to entry are not infinitely lived. - One appropriate question to ask in framing the life question under the broadest definition would be Standing at the date of the valuation of the contribution, for what duration would I expect intangible development efforts to produce returns that are in excess of appropriate capital costs given the risk of investment? At the same time, the non-maintenance approach often employed by taxpayers under the old cost sharing regulations would clearly not capture the value of rights to continue to invest. This value is clearly meant to be captured in platform contribution transaction payments under the temporary cost sharing regulations. - To do otherwise would violate the tenants of the investor model embedded in § T(g)(2)(ii) and the realistic alternatives requirement of § T(g)(2)(iii) 3

4 What is Useful Life? The income method values contributions by calculating the net present value of residual income that a given participant expects to generate by exploiting the contribution. By definition, a positive terminal value under the income method embeds an assumption that intangibles have infinite lives. If, for TV calculations, g>0, residual profits are assumed to grow forever. If g<0, residual profits will eventually converge to zero Terminal value calculations that incorporate positive growth (or even slow rates of decline) assume intangible lives (under any definition) that stretch credibility. 4

5 What is Useful Life? When valuable contributions are made at the inception of a cost sharing arrangement, the expected profitability profile associated with exploiting those intangibles might look something like this 5 Residual Profits Time As expected returns to intangible development activities converge to the risk-adjusted cost of capital, residual profits decline Projected residual profit path under the non-maintenance framework Projected residual profit path under valuations with non- negative growth rates in terminal value calculations

6 Measuring Useful Life To some extent, useful life under the excess returns on IDCs framework might be observable through profitability projections. - Profit projections may not be made for a long enough period to observe decay in expected profitability; - Profit projections may also be too rosy in that they assume ongoing excess returns not because of pre-existing intangibles, but because of overly optimistic expectations of returns relative to legitimate time zero projections Are the projections coming from taxpayers incorporating the same time zero frame of reference that the analyst would need to be for purposes of establishing PCT payments? Some points of information that may be helpful for establishing useful lives under the excess returns on IDCs framework: - Historical trend in market share: How long, on average, does it take high market share companies to mean revert based on historical data? - McKinsey & Companies empirical analysis shows that high ROICs tend to mean revert over a 15 year period. Obviously, this is likely to vary across industries (see Valuation: Measuring and Managing the Valuation of Companies). 6

7 Thank You Mark Bronson Ceteris Direct:

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