Interstate intangible asset transfer programs. (includes related article)by Nesi, Nicholas A.
By their nature, intangible assets are often overlooked as the subject of active management. Company management acquires or develops the assets, debate the period over which they should be amortized, instruct the CPAs to prepare appropriate lapse schedules, and go on to other things. Many do not recognize or explore options available to maximize the income to be derived from those assets or other benefits of a centralized intangible asset management program.
There are numerous legal, business, and operational reasons for implementing an intangible asset management program. At its basis is the transfer of ownership of the intangible assets to a separate corporation under the control of active management. By choosing the situs and operating form of the corporation holding the intangibles, a very tangible benefit may be the reduction of the total state tax obligation of the consolidated entity holding the assets.
More specifically, in recent years many corporations have formed subsidiaries in the State of Delaware and then transferred legal title to various intangible assets and intellectual properties to them. In the most common structure for this program, the entity transfers intangible assets such as trademarks and trade names to the newly organized Delaware subsidiary. As part of its normal business operations, the Delaware subsidiary licenses the use of the trademarks and trade names to the related business interests in other states. The business pays a license fee or royalty payment to the Delaware corporation for the use of the trademarks and trade names now owned in Delaware. There is no tax liability in the State of Delaware for income derived from licensing or leasing intangible assets, e.g., royalties received for the use of trademarks. The intercompany payments from outside Delaware-the same royalty payments for the use of the trademarks - represent deductible expenses for determining taxable income in other states in which the entity generates business income. The net result therefore can be a reduction in the total state income tax obligation of the consolidated entity. The accompanying sidebar presents an example of tax savings generated in this manner. Consolidated federal income tax expense, however, is obviously not affected by this asset transfer program.
This article presents valuation, economic, and corporate management aspects related to the design and implementation of an intangible asset transfer program. Some of the issues include identification of specific intangible assets to transfer, creation of the Delaware corporation, methods of quantifying arm's-length transfer prices for the intangible assets, and the most significant economic pros and cons of installing an intangible asset transfer program.
For an intangible asset to exist from a valuation, accounting, and legal perspective, it must possess certain attributes, some of which are listed below:
* Be specifically identifiable and recognizable.
* Have legal existence and protection.
* Be subject to private ownership, which is legally transferable.
* Have tangible evidence or manifestation of existence, e.g., a contract, a license, or a registration document.
* Was created or came into existence at an identifiable time or as the result of an identifiable event.
* Is subject to destruction or termination of existence at an identifiable time or as the result of an identifiable event.
In other words, there must be a specific bundle of legal rights, and other natural properties, associated with the existence of any intangible asset.
For an intangible asset to have a quantifiable value from an economic perspective, it must possess certain additional attributes, some of which are listed below:
* Generate some measurable amount of economic benefit to its owner. This economic benefit could be in the form of an income increment or a cost decrement, which may be measured in any of several ways including, net income, net operating income, or net cash flow, etc.
* Enhance the value of other assets with which it is associated; the other assets may include tangible personal property and tangible real estate.
There may be a substantial distinction between the legal existence of an intangible asset and the economic value of that asset. An example would be the new registration of a legally binding and enforceable patent that, upon creation, is immediately and permanently locked in the corporate vault. If the patent is never used in the production or protection of income it has no economic value - even though it has legal existence.
Generally, appraisers categorize individual intangible assets into several distinct categories. These categories are used for general asset identification and classification purposes that are relevant when implementing an intangible asset transfer program. The assets in each category are generally similar in nature and function. Also, assets are grouped in the same category when similar valuation and transfer pricing methodologies apply.
The most common categories of intangible assets follow:
* Technology-related, e.g., engineering drawings;
* Customer-related, e.g., customer lists;
* Contract-related, e.g., favorable supplier contracts;
* Data processing-related, e.g., computer software;
* Human capital-related, e.g., a trained and assembled workforce;
* Marketing-related, e.g., trademarks and trade names;
* Location-related, e.g., leasehold interests; and
* Goodwill-related, e.g., going concern value.
One special classification of intangible assets, known as intellectual properties, has all the legal existence and economic value attributes of other intangible assets. Because of their special status, however, intellectual properties enjoy special legal recognition and protection. Unlike other intangible assets, which may be created in the normal course of business operations, intellectual properties are created by intellectual and/or inspirational activity. Such activity, although not always planned, is specific and conscious. The creativity of identifiable, specific individuals can be attributed to the activity. Because of this unique creation process, intellectual properties are generally registered under and protected by specific federal and state statutes.
Like other intangible assets, intellectual properties are generally grouped into categories. The intellectual properties in each category are generally similar in nature, feature, method of creation, and legal protection. Likewise, similar valuation, transfer pricing, and other methods of economic analysis would apply to intellectual properties in each category.the most common categories of intellectual properties are creative, e.g., copyrights, and innovative, e.g., patents.
Trademarks and Trade Names
Corporate trademarks and trade names are the most common intangible assets found in intangible asset transfer programs. Because of the critical importance of corporate trademarks and trade names combined with the need to protect, manage, and control their use, corporations in the retail industry frequently avail themselves of this intangible asset transfer strategy. Corporations in wholesale, distribution, manufacturing, service, and other industries may also have the same needs, making the use of an interstate intangible asset transfer program a viable strategic option for many industries.
In determining which intangible assets to include in an interstate transfer program, a taxpayer should consider which corporate intangible assets:
* Have legal existence;
* Have economic substance;
* Can be legally transferred to a Delaware corporation;
* Have a practical business reason for being transferred to the Delaware corporation;
* Are actually used, or used up, in normal business operation in other states;
* Can be associated with a determinable royalty rate or other transfer price, in order to effectively quantify the asset transfer program;
* Have a reasonably long term, and determinable, remaining useful life;
* Will not have to be sold, abandoned, or otherwise transferred back out of the Delaware corporation in the foreseeable future.
In the case of trademarks and trade names, a number of additional issues should be considered including, should:
* All trademarks and trade names be transferred?
* Only the overall corporation trademark be transferred?
* All individual brand, product, and service marks be transferred?
* Future trademarks and trade names be transferred as they are developed?
* The trademarks be transferred in perpetuity or for a specified limited term?
These questions cannot be answered in a vacuum. They can be answered only after careful consideration of the selection criteria above and after thorough consideration of the corporate purpose and objectives of the intangible asset transfer program.
CREATION OF THE
Besides advising in the creation of a corporate entity to be domiciled in Delaware, qualified legal counsel is also necessary before the taxpayer implements any intangible asset transfer program. Title to the trademarks, trade names, and/or other intangibles should be effectively transferred to the newly created Delaware corporation, using legal counsel familiar with intellectual property law.
The newly created Delaware corporation should have both form and substance. There should be a legitimate business purpose, other than the exclusive goal of minimizing consolidated state tax liability. One traditional corporate purpose for the asset transfer program is to allow the business entity to better control its intangibles. This means internal, as well as external control, and would include accounting, legal, administrative, and operational controls. Another common corporate purpose for the asset transfer program is to allow the corporation to explore the possibility of licensing its trademarks, trade names, technology, copyrights, and other intangible assets. The Delaware corporation would be the vehicle to license various intangible assets to independent, third-party licensees in arm's length transactions. As with all stated corporate goals and objectives, these purposes do not ultimately have to be achieved.
To accomplish its business purpose, and to achieve substance as well as form, it is not unusual for the corporate parent to transfer assets, other than intangibles, to the newly created Delaware corporation. Often, the parent will transfer cash balances and certain banking relationships to Delaware. Also, employees are frequently placed on the payroll of the Delaware corporation. These employees may be responsible for the management and control of the firm's intangible assets. They may also be accountable for developing and implementing the firm's intangible asset licensing programs.
As with any functioning business enterprise, the newly created Delaware corporation should prepare financial statements on a periodic basis. These statements should report the results of operations and the financial position of the corporation. The results of operations will include any licensing and investment income less the payroll, rent, utilities, and administrative costs of the business operations. Administrative, accounting, or other services provided to Delaware business operations should be charged through intercompany accounts to the Delaware corporation. The Delaware corporation's balance sheet will include among its assets the transferred intangibles.
VALUATION OF ASSETS
Unlike a traditional appraisal performed for financing or other purposes, the primary objective in valuing the assets transferred is to determine a fair, arm's-length transfer price based on the future use or license of the transferred intangible assets. The secondary objective of the appraisal is to determine the reasonable period over which intercompany payments should be made for the transfer of the intangible assets. Like tangible assets, the value of most intangible assets wastes or diminishes over time. The term of the intercompany transfer payments should reflect this wasting, or value diminution, if any.
However, like a traditional asset appraisal, there are generally three accepted categories of approaches to determine the appropriate transfer price for the subject intangible assets, the cost, market, and income approaches.
Using the cost approach, the transfer price is based upon a fair return on the cost to recreate the functionality or utility of the subject intangible assets.
First there are several methodologies to quantify a fair return. For example, a fair return may be quantified by reference to returns earned by a sample of guideline or comparable publicly traded companies. A fair return may be quantified by reference to average rates of return earned in the industry in which the asset transferor operates. It should be noted that it is difficult to obtain and analyze public data regarding comparable rates of return, since these returns are usually not associated with specific intangible assets. Also, a fair return may, be quantified by reference to the cost of capital to finance the subject assets at the transferor firm. Since it is difficult to quantify an asset-specific cost of capital, and since the transferred intangibles are presumably used as part of the overall going concern business enterprise, a weighted average cost of capital is often used as proxy for a fair return on transferred intangible assets.
Second, there are several methodologies to quantify the cost to recreate intangible asset utility. These methodologies include depreciated replacement cost, depreciated reproduction cost, recreation cost, creation cost, cost savings or avoidance, or other methodologies. All of the related methodologies share a common objective to quantify the cost in current dollars necessary to generate a perfect substitute to the subject assets in terms of functionality, utility, usefulness, and remaining life. For example, applying this approach to trademarks and trade names, appraisers would estimate the cost to recreate the current level of brand awareness, customer loyalty, product/service recognition, and consumer acceptance, of the subject names. This estimate could be determined by trending (using an inflationary factor) historical advertising, promotion, selling, product deals, price discounts, and other name-related marketing expenditures. This estimate could also be determined by analyzing actual costs associated with recent comparative name introductions of the subject firm or of guideline firms.
Third, when using this approach, it is important to quantify the costs related only to the subject intangible assets. Appraisers should avoid double counting or otherwise overstating the costs and, therefore, the transfer price of the specific intangible assets included in the asset transfer program. For example, if the appraisal objective is to determine the transfer price related to trademarks, then the appraiser should be careful not to include the cost of creating the subject firm's customer list, favorable location, trained and assembled workforce, or goodwill.
Using the market approach, the transfer price is based upon an analysis of actual arm's-length transfer-price agreements of comparable intangible assets.
First, the appraiser determines the objective criteria for determining the comparability of intangible assets involved in arm's-length transactions and the subject intangibles. These criteria may include type of intangible, use of the intangible, industry firm size, term of the license agreement, de novo versus seasoned agreement, de novo versus seasoned asset, etc.
Second, the appraiser surveys the appropriate secondary market, and using the objective criteria above, selects for analysis a sample of guideline license agreements, royalty contracts, franchise covenants, cost share arrangements, asset leases, and similar agreements. These agreements should all be arm's-length transactions, between independent parties involving assets and transfer agreements comparable to the subject assets.
Third, the appraiser selects the most appropriate transfer price for the subject intangibles after rigorous review and comprehensive analysis of the arm's-length guideline transactions. A simple mean or median royalty rate of the sample transactions may not be appropriate for the subject assets. Based upon the objective criteria, the appraiser may select a transfer price that is not within, although derived from, the range of guideline transaction transfer prices. For example, the appraiser may analyze several arm's-length discount retail store trademark license agreements with royalty rates ranging from 1.75% of net sales to 2.25% of net sales. Yet, after comparing the subject assets to the guideline transactions, the appraiser may ultimately select a royalty rate of 2.50% of net sales as the appropriate transfer price for the subject trademarks.
Using the income approach, the transfer price is based upon some measure of the incremental economic income earned by the firm associated with the use of the transferred intangible assets.
First, there are several measures of economic income, depending upon the type of asset, the type of firm, and the nature of the industry. Some common measures of economic income include profit margin-gross or net, return on investment-measured as total assets, net assets, or owners' equity, and net cash flow-before tax or after tax, before debt service or after debt service. Economic income measures can involve any increment in economic income or decrement in economic costs.
With regard to quantifying a transfer price for trademarks and trade names in the retail industry, for example, the following measures of economic benefit are often used: sales per square foot of selling floor space, advertising expense as a percent of sales, promotion expenses as a percent of sales, mark downs or product discount expenses as a percent of sales.
Second, the economic benefit of the subject intangible asset should be comparable and based upon an absolute scale. This means that the operating results of the appraisal subject should be compared against some objective benchmark. The objective benchmark, for example, may be industry average data, mean or median data related to a select sample of guideline publicly traded firms, or the historical performance of the subject firm before it had a recognized trademark and trade name.
Third, the economic benefit should be associated with the transferred intangible asset. In other words, the incremental value and economic benefit of other, non-transferred intangible assets should be identified and isolated before the economic benefit to be associated with the transfer price is quantified. For example, if the subject firm enjoys favorable leases, supplier contracts, technology or other intangibles, assuming these assets are not transferred to the Delaware subsidiary, then the economic impact of these assets should be culled from the operating results of the subject firm before the asset transfer price is determined.
Ideally, the finally derived asset transfer price will be based upon a synthesis of two or even three of the valuation approaches. Depending upon the quantity and quality of available data, however, it may be acceptable to rely upon one valuation approach in the final determination of the intangible asset transfer price.
The most common intangible asset transfer pricing formula is one where the transfer price is expressed as a percentage of net sales, e.g., the fair transfer price for a retailer's trademarks may be 1.5% of net sales. However, transfer price formulae based on a percent of gross profit or net profit is not uncommon. Particularly for technology related intangible assets of a manufacturing firm, e.g., engineering drawings or patents, a transfer price equation based upon number of dollars per units produced or units sold is not unusual.
Over time the transfer price formula is likely to change for most business entities. Many companies that have implemented these asset transfer programs reevaluate their transfer pricing formula periodically, some on an annual basis.
If economic conditions in an industry change, if the micro-economic dynamics of the company change, or if the intangible asset begins to experience obsolescence or other forms of economic decay, then the appropriate transfer price formula should change. Even if over the course of time the three valuation approaches remain valid, their periodic application may result in differing valuation syntheses and transfer price rates.
The determination of the expected remaining useful life of an intangible asset will obviously impact the results of any of the three valuation approaches. For example, other things being equal, an intangible with an expected remaining life of three years will have a lower depreciated replacement cost than the same intangible with an expected remaining life of 15 years. Also, the shorter lived asset will generally fetch a lower market-derived royalty rate and produce a lesser incremental economic benefit than some objective benchmark measure.
More importantly, the estimate of the remaining useful life of the subject intangible asset will directly influence the term over which the related corporations will be willing to pay a transfer price to the Delaware corporation. In an arm's-length transaction, a lessee would not continue to pay rent or royalties to a lessor beyond the useful life of the assets.
There are numerous ways to measure the expected remaining life of intangible assets. Some of these measures include:
* Physical life;
* Functional life
* Technological life
* Economic life
* Contract life
* Statutory/judicial life
* Legal/regulatory life; and
* Actuarial mortality life.
Generally, the shortest remaining useful life measure is used to structure the period for making transfer payments. For example, it may not be particularly relevant that a certain trademark has a 10-year remaining legal (trademark registration) life, if the trademark will become economically obsolete, and its use discontinued in three years. An estimate of the remaining useful life of the transferred intangible assets is a familiar ingredient in resolving the term of the transfer price agreement.
As with any asset management or other corporate strategy program, there are costs as well as benefits. These costs should be understood and budgeted before management chooses to implement an intangible asset transfer program.
The asset program could include significant set-up costs such as qualified legal and valuation advice, a new Delaware corporate entity, as well as the costs associated with transferring assets, personnel, and operations. Also, consideration should be given to the indirect costs associated with possible disruption to the business enterprise during the creation and implementation of the asset transfer program.
In addition to the start up costs, there will probably be continuing administrative costs associated with maintaining the asset transfer program. These costs, as noted earlier, include ongoing periodic legal and valuation advice. In addition, various states may challenge the appropriateness of the asset transfer price. These challenges may come as part of an audit of the impact of the intercompany transfer pricing on the parent corporation's total state income tax liability.
The greatest risk facing a prospective user in an asset transfer program is an unexpected change in the value of the transferred asset- and the corresponding change in the transfer price. After the program is implemented and the assets are transferred, the fair arm's-length transfer price may change due to unanticipated asset obsolescence or economic changes in the industry or the subject business entity. This is one reason many corporations re-evaluate the fair transfer price formula periodically. Such events could materially affect the cost/benefit considerations concerning an asset transfer program. There is no effective way to insure against the occurrence of such events.
A valuation firm experienced with intercompany transfer pricing analysis should be able to reasonably estimate a fair transfer price formula and an expected remaining life of the transfer agreement on a preliminary basis. These preliminary estimates should be adequate for planning, evaluation, and decision making purposes. A more rigorous and thorough valuation and analysis of the remaining economic life of the intangible asset would be required in the actual pricing and structuring phase of implementing the intangible asset transfer program.
WHAT WILL YOU ADVISE?
As with any strategic planning technique, there are pros and cons to implementing an intangible asset transfer program.
In terms of the pros, the business entity may enjoy increased internal and external control over its intellectual properties. It may implement a legal and an organizational structure to investigate licensing, or otherwise maximize the value of its intellectual properties. And, there may be substantial state income tax management opportunities associated with an intangible asset transfer program.
As to the cons, the business entity may experience significant transfer program implementation costs, including a cost/benefit analysis study, legal fees, valuation consulting fees, and all the temporary organizational disturbances associated with implementing the program. There may be recurring legal and valuation consulting fees, particularly if certain states decide to challenge the transfer pricing formula. Last, there is the risk that the value - and the associated transfer price - of the transferred assets may change over time. And this risk is not always within the control of corporate management.
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