www.internationaltaxreview.com Tax Reference Library No 24 Intellectual Property (4th Edition) Published in association with: The Ballentine Barbera Group Ernst & Young FTI Consulting
How to use transfer pricing to calculate the value of a brand By Alexander Voegele, Stuart Harshbarger and Nihan Mert-Beydilli, NERA Economic Consulting How much is a brand worth? The valuation of brands and the calculation of royalties for brands are based, among other things, on product or service attributes, presentation impact, any related or associated trade or service marks, and consumer perceptions of the brand. When valuing intellectual property (IP), practitioners will typically rely upon the results gained from applying various standard methods such as a comparable uncontrolled transactions (CUT) method or the profit-split method (PSM). Brands are a unique subset of intellectual property requiring specialized treatment. As a preliminary observation, brands are considered to be intangible assets. An intangible is an asset that comprises any of the following items and has substantial value independent of the services of any individual: patents, inventions, formulas, processes, designs, patterns, or know-how; copyrights and literary, musical or artistic composition; brands, trade marks, or brand names, trade dress or packaging; franchises, licences, or contracts; methods, programs, systems, procedures, campaigns, surveys, studies, forecasts, estimates, customer lists, or technical data; and other items that derive their value not from physical attributes but from their intellectual content or other intangible properties. Within this broad category of intangible assets resides a subset of IP. The term IP is used here to refer to a special class of intangible assets with legally protected property rights. Intangible assets and IP are not equivalent: for example, a skilled sales force may be a valuable intangible asset but it is not IP. Intellectual property is distinguished by its ability to be transferred from licensor to licensee or from seller to buyer. Patents, brands, and copyrights are some of the more widely traded types of intellectual property. The particularities of brands In many countries, brands may not be legally protected and enforcement of existing statutes may be negligible. The term brand means different things to different sets of consumers. Very often the expression brand is wrongly used as a synonym for individual trade names and trade marks. Unlike other types of IP such as patents, the value of a brand may be contingent upon the joint efforts of both the licensor and licensee. The value of a brand is created not only by the activities of the parent company, but also by the sales efforts of each related affiliate. Local sales volumes and accompanying profitability of affiliates appear in many instances to be only weakly related to global marketing efforts. This is especially true with respect to consumer products: if local advertising and customer development ceases, sales will decline rapidly regardless of what success the www.internationaltaxreview.com 3
Biography Stuart Harshbarger 1157 Concord Avenue Detroit, MI 48207 US Tel: +1 313 267 9500 Fax: +1 313 267 9501 Email: stuart.harshbarger@nera.com Stuart Harshbarger is a vice-president in NERA's transfer pricing and intellectual property practices. He specializes in the economics associated with the manufacturing industries. He has completed global transfer pricing studies for US, European, and Japanese manufacturing companies, with an intensive focus on plant costing, performance, and profitability metrics. Harshbarger has also completed transfer pricing studies for over 30 different automotive parts manufacturers. Before joining NERA, Harshbarger worked for PricewaterhouseCoopers, where he was responsible for completing transfer pricing, intangible asset valuation, and management fee studies for companies worldwide. He has also worked at DRI/McGraw-Hill, Argonne National Laboratory, the Washington Gas Light Company, and the US Department of Energy. He is a sustaining member of the Detroit Economic Club. brand may be having in other countries. Affiliated companies tend to collectively contribute and participate in giving a brand its value. A further complication is created by M&A. The total value associated with brands is often defined by a diverse portfolio of intangible assets, IP, and consumer perceptions, such as expected levels of customer service and quality. Over time, this portfolio of attributes will change due to acquisitions, mergers, and sales of existing operations. The acquisition of other companies with valuable brands in other countries commingles existing IP with newly acquired IP, creating economic and legal ownership issues for transfer pricing economists to study. Brand value is based on a portfolio of assets that is constantly changing over time. It is highly unlikely that only one company within one group is the economic owner of all the value associated with a brand. Several licensors often exist within one group, leading to the problem that at arm s-length, royalties have to be paid to several licensors. In contrast to other types of IP, brands require ongoing promotion and development to remain valuable. Although a patent may signal the end of development for a particular product or process, brands require constant development and updating to remain valuable. Participation by affiliates may influence the value positively or negatively. Positive as well as negative remarks in the local press or on television may have a significant impact on the value of brands. Licensor and licensee have to agree on the definition of future cost, on the bearing of this future cost, on the potential buy-in payments, on the rights created by these activities, and finally on the royalties to be paid. The foreseeable participation by all parties in the development of the brand has to be reflected in the royalty agreement. Therefore these activities have to be carefully investigated and the future costs have to be paid by the owner or beneficiary of the brand, many activities leading to an increasing or decreasing value of a brand are not foreseeable. Establishing brand value also requires practitioners to quantify elements that are inherently qualitative such as brand attributes and consumer perceptions. The value of qualitative elements is different depending on the type of product, the type of customers and the individual market. Although the brand may be significant for some products of one affiliated company, it may have virtually no importance for other products within the same group of companies using the same brand. In practice, there are very few truly global brands which are universally known and accepted. Similarly, the orientation of economies varies by country and region in keeping with differences in consumer preferences and business practices. Global royalty regimes that do not address this heterogeneity among markets are under increasing scrutiny by tax authorities. A few of the most problematic tax audits have resulted from the implementation of royalty payments that do not distinguish between different markets or product groups. Collectively, these types of unique considerations argue for treating brands as a special subset of IP requiring different analytical treatment. Recommended procedures to calculate brand royalties First, employment of traditional profit-split procedures should be completed to segment the economic activity being examined into routine and non-routine functions. The starting point for this process is a detailed functional and risk analysis for each subsidiary or party to the transaction. After this informational gathering step is completed, a series of database screenings should be conducted to identify similar companies who do not possess valuable intangible assets. These companies can be identified through numerical screening techniques that may consist of market-to-book ratio screens, or advertising-to-sales ratio screens. The purpose of this exercise is to identify an arm s-length range of compensation for the performance of routine functions. Routine functions are those that are not proprietary, are universal to running a particular business, and can easily be obtained from numerous firms in the marketplace. Routine functions do not require specific know-how and are not connected with high business risk. There are many examples of 4 www.internationaltaxreview.com
routine functions, such as basic metal stamping by manufacturers or general administrative services performed by a corporate headquarters facility. The economic returns associated with the comparables are then imputed to the routine functions and this revenue is deducted from the total profit of the economic activity being examined to quantify the residual or intangible profit earned by the entity. At this point, several significant challenges remain. The remaining intangible income is often a function of many different types of intangible assets consisting of IP, brands, and a wide variety of other intangibles. In some instances, it may be the case that a company s only intangible assets are brands, however, this type of a situation is quite rare. A more typical situation consists of residual profitability being defined by brands, patents, and many other types of intangible assets. It is therefore necessary to calculate the part of the company s IP that is represented by the brand. Second, once traditional profit-split methods have been used to segment profitability between a return to routine and non-routine functions, these methods should again be reviewed to see if these modalities can be applied to further segment non-routine income between brand and non-brand residual income. It may be possible to use traditional residual allocation mechanisms reliably such as the amount of capital employed, sales revenues, or headcount considerations to further segment between brand and non-brand specific income. In many instances, this exercise may not bear fruit. However, it is important that such an evaluation takes place as part of a one s due diligence. If, as is sometimes the case, the application of pre-existing transfer pricing methods to a particular situation does not work to segment brand vs non-brand residual income, then economic reasoning-type arguments will generally be used based on available data and the education and experience of the practitioner who is performing the brand valuation. Very often a formulaic approach is postulated that says in effect according to the experience of the analyst the residual profit should be shared such that one-fourth to one-third of the residual income is due to ownership of the brand by the licensor and the remaining part belongs to the licensee. These types of discussions are usually surrounded by detailed tables, appendices, and carefully written regulatory summaries to add gravitas to what is essentially the opinion of a few consultants who may know very little about the industry in which they are working. A more objective and perhaps arm s length approach would be to solicit in a formal way the opinions of experts who are working in the particular industry being studied. Biography Nihan Mert-Beydilli 875 North Michigan Avenue Suite 3650 Chicago, IL 60611 US Tel: +1 312 573 2855 Fax: +1 312 573 2810 Email: nihan.mert.beydilli@nera.com Nihan Mert-Beydilli is a senior consultant at NERA, specializing in intercompany pricing and valuation analyses. Her areas of expertise include designing pricing methodologies, determining appropriate intercompany prices (for example, arm's-length royalty rates), assisting clients to negotiate and implement APAs with tax authorities and supporting clients in tax controversy situations. She has advised multinational corporations in sectors including automotive, construction and industrial machinery, information technology services, and power generation. Mert-Beydilli has also worked on management consulting engagements and previously spent several years working as a qualified environmental engineer. Before joining NERA, Mert-Beydilli worked in the economics group of AT Kearney's strategy practice. She holds an MBA from Brandeis University in the US and an MSc in environmental engineering from the University of Newcastle-upon-Tyne in the UK. Calculating brand royalties using comparable market opinions An adviser can borrow a widely used technique in the forecasting of popular economic variables such as the rate of inflation or projections of unemployment. The most reliable forecasts tend to be based upon a consensus or average forecast from many different viewpoints. The approach is to identify expert observers both inside and outside of a company who are uniquely qualified to offer an expert opinion on the value of a particular brand and how much third parties would be willing to pay for the opportunity to use the brand being valued. Ideally, outside expert opinions should come from employees of comparable companies within the same industry as the tested party. The objective is to find expert opinions and to use these observations to obtain a range of royalty rates for the brand being studied. Perhaps one difficulty about using this approach is concern about protecting the confidential nature of company information given that companies within the same industry are often competitors. There are two obvious ways that can be used to protect the identity of the owner of the brand being valued. First, the information set given to experts must be premised on a hypothetical situation with made up data sufficient to protect the identity of the brand owner but clearly demonstrating the economics involved. Second, selected outside experts must sign confidentiality agreements with the interviewer as a further measure of protection. A less obvious way to add even more protection would be to not identify individ- www.internationaltaxreview.com 5
Biography Alexander Voegele Grosse Bockenheimer Strasse 13 60313 Frankfurt am Main Germany Tel: +49 69 133 8531 Fax: +49 69 133 8535 Email: alexander.voegele@nera.com Alexander Voegele is chairman of the advisory board of NERA Economic Consulting. For over 25 years he has specialized in the development of innovative economic structures for transfer pricing strategies, and in defending major international transfer pricing cases. Voegele and his NERA colleagues provide economic transfer pricing strategy and planning to clients facing M&As, dealing with organizational structuring and incentive management issues, and in need of market pricing evaluations. Having negotiated numerous bilateral and multilateral agreements involving Germany, France, the US, Japan, Canada, Mexico, and Australia, they have particular expertise structuring European arbitration and advance pricing agreements. They specialize in worldwide documentation, and valuing business and intellectual property. Voegele publishes articles and books on transfer pricing, including the leading German commentary, Handbook of Transfer Pricing. He speaks at conferences in Europe, the US and Asia. ual experts by name or company affiliation. This latter consideration is often employed to boost response rates to consumer and business surveys and is universally used by surveyors. Problem of subjectivity The calculation of brand royalties is one of the most subjective tasks in the area of IP valuation. Some of the existing transfer pricing approaches have a few well known deficiencies. Perhaps one problem in brand valuation is the amount of individual subjectivity that occurs because a lack of information prevents a reliable application of existing transfer pricing methodologies. One way to improve upon this situation is to collect opinions from outside experts and to use this range of estimates as an impartial arm s length pricing mechanism. Such an approach is recommended because the collected opinions come from local experts who are in the best position to assess the value of brands within the local marketplace. 6 www.internationaltaxreview.com
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