Authors: Alan M. Cody, Judd G. Scheider, and Marco Mura
Alan M. Cody is a Managing Director, Judd G. Scheider is a Director, and Marco Mura is a Vice President of Duff & Phelps, LLC
As the economy recovers and taxable profits reemerge, companies are beginning to assess whether a tax restructuring of their operations to better align areas of geographical growth and relative tax rates makes sense. These restructurings may result in the consolidation or movement of ownership of legal entities from one jurisdiction to another, potentially triggering taxable events. To ensure a tax-efficient restructuring, this may require the estimation of the fair market value (FMV) of anywhere from a few to several hundred legal entities, depending upon the scope of the restructuring. This Practice Alert, which is excerpted from a more extensive article in the November/December 2010 issue of Corporate Taxation, discusses defensible legal entity valuations.
Proper valuation of the legal entities involved, including an ability to defend the values and methodologies applied before relevant tax authorities, is key to a defensible restructuring. A proper and defensible valuation, in part, means that the valuation should be completed by a qualified, independent appraiser, as defined in the Code and regulations.
In contrast with a stand-alone business valuation, a legal entity of a controlled group is valued as part of a business network that may include significant intercompany relationships. Most multinational companies’ operating legal entities have a defined role as a captive manufacturer, an intellectual property holding company, a cost center that supports other entities, or a distributor, among other roles.
Transfer pricing policies. In each of these cases, the projected profits should give specific consideration to transfer pricing policies among the entities (e.g., an allocation of a certain level of profit for manufacturing a product, a royalty for the right to sell a software product, or an intercompany service agreement for provision of administrative services) as well as their respective business environments. Transfer pricing policies among legal entities should follow appropriate transfer pricing regulations and statutes, depending on the countries in which the entities operate.
Premise of value. In valuing the legal entities of a company, a decision must be made whether to assess the legal entities on a stand-alone or an aggregate basis. The selection of a proper premise of value is important because it impacts certain valuation assumptions, including the development of the discount rate, assumed tax rates, and applicability of discounts for lack of marketability and lack of control.
Legal entity transactions are most often structured as aggregate sales. An aggregate sale can either be a single bundled sale or multiple sales of divisions or reporting or business units. The premise of value selected must reflect the manner in which a hypothetical buyer and seller would structure the transaction. In other words, the determination of an appropriate premise of value must be consistent with the FMV concept.
In the authors’ experience, the pool of hypothetical buyers is generally comprised of large companies or private equity firms who buy entire consolidated companies or business units, not individual legal entities on a piecemeal basis. Buyers evaluate the purchase price of the legal entities on an aggregate basis rather than on a stand-alone basis. Likewise, sellers seek to maximize value, and more often than not, higher proceeds can be achieved through an aggregate sale.
Valuation approaches. Three basic approaches are typically considered when estimating the FMV of operating and non-operating legal entities: the income, market, and net assets approaches.
Income approach. The income approach is a valuation technique that provides an estimation of the FMV of a legal entity based on the cash flows that a business can be expected to generate over its remaining useful life. The projected cash flows are then converted to their present value equivalent using a rate of return (or discount rate) appropriate for the risk of achieving the projected cash flows.
Legal entity discount rate inputs should be consistent with the premise of value selection. For example, if a stand-alone premise of value is selected, the size premium should reflect the business and financing risks associated with the individual legal entity. However, if it is more likely that the legal entities would be transacted on an aggregate basis, the size and risk characteristics of the legal entities should be viewed on the parent, divisional, or reporting level (i.e., the level upon which the legal entities would most likely be sold). The risk profiles of businesses are integrated with those of a larger parent or division and, therefore, are not generally viewed in isolation.
It can be argued that a buyer’s willingness to pass along the benefits of size (in the form of a lower cost of capital) is a synergy commonly seen in most transactions. This is particularly true if the seller is also a large company selling only one piece of its business—it is not likely to accept a lower price based on the premise that a stand-alone business would have a higher risk profile, thus requiring a higher cost of capital.
Assumptions regarding legal entity tax rates are dependent on whether the income of the legal entity will stay within its home country or be repatriated to the home country of the hypothetical purchaser. Since most multinational companies align their legal entity structures to take advantage of local country tax savings, income is generally not repatriated when the tax rate of the parent company is higher than that of the local country.
Market approach. The market approach is a valuation technique that provides an estimation of the FMV of a legal entity based on comparable firms in similar lines of business that are publicly traded, or which are part of a public or private transaction, including prior company transactions.
Net assets approach. The net assets approach is a valuation technique that provides an estimate of the legal entity’s FMV by adjusting the asset and liability balances of the legal entity (typically, a non-operating or holding company) balance sheet to their FMV equivalents. The FMV of equity is then indicated by the difference between the adjusted asset and liability balances.
Operating legal entities are typically valued using an income approach, i.e., based on projected revenues and costs that are then converted to cash flows and discounted to present value over a specified period, along with a residual value. The premise of value and the economic function and location of the legal entity play an important role in calculating an appropriate discount rate for the projected cash flows and selecting the long-term growth rate for estimating the residual value.
A market approach may also be considered in arriving at the FMV of an operating legal entity or solely to corroborate the income approach result. Ultimately, the selection of the appropriate valuation approach(es) should be based on the requirements of the tax jurisdiction(s) for which the valuation analysis is being prepared.
Lessons learned in defending valuations. The experience of multinational firms in planning and executing legal entity restructurings, and the authors’ assistance with the required valuations, have provided several lessons. In particular, they have shown that a defensible valuation requires the following:
… Projections of revenues, costs, and margins that appear to be reasonable when benchmarked against publicly traded companies that have a comparable business description, and (ideally) operate in similar geographic regions and perform the same general function(s) as the subject legal entity;
… Consistency of legal entity-level projections with total company, business unit, and/or overall restructuring plan projections, where applicable;
… Consistency of operating assumptions with those applied in other valuations prepared for financial reporting purposes;
… Independent industry and economy-specific support for assumed short and long-term revenue growth rates;
… Adjustments of margins for cross-entity use of intellectual property and other intercompany arrangements (i.e., absorption of certain overhead costs) and consistency of intercompany transfer pricing assumptions, in a manner compliant with the relevant regulatory transfer pricing guidelines, for both tangible and intangible property with other internal transfer pricing documentation;
… Discount rates consistent with currency projections, industry and country risk, and volatility; and
… Analysis of intercompany receivables and payables to ensure that they are treated appropriately (e.g., working capital in nature or more akin to debt financing) when estimating a legal entity’s enterprise and equity value.
It should be noted that third-party appraisers are required by IRS Circular 230 (Reg. § 10.0 et seq.) guidance and other appraisal standards to rely on client data as long as it is tested for reasonableness through discussions with management and compared to industry and comparable benchmarks, when available.