Intangibles, transfer pricing considerations and their valuation

Part 2 — Pricing, comparability and valuation

Dr. Paul Valdivieso, PhD (Econ), MSc, MBA

A practical guide for tax professionals, considering the OECD Transfer Pricing Guidelines (January 2022). Paragraph references appear in parentheses, e.g. (6.42).

This is the second of three parts. Part 1 dealt with the questions that precede any pricing exercise: what counts as an intangible, and which entity in a group is entitled to keep the profit one generates. Part 2 turns to the pricing itself — selecting a method, working through comparability, and valuing intangibles for which no reliable comparables exist. Part 3 completes the series with documentation and the key practical considerations.

Part 1 closed on a distinction worth restating, because everything below depends on it. Identification establishes which intangibles are in play. Entitlement establishes which entities have a claim on the return. Step six of the framework at 6.34 is pricing.

Section 1 — Method selection and comparability

The five methods, briefly

For readers coming from general tax: transfer pricing recognises five methods. Three are “traditional transaction” methods — CUP (comparable uncontrolled price: what did an unrelated party pay for the same thing?), resale price, and cost plus. Two are “transactional profit” methods — TNMM (transactional net margin method: does the tested entity earn a net margin comparable to independents doing similar things?) and the transactional profit split (divide the combined profit between the parties by reference to their relative contributions).

CUP, resale price, cost plus and TNMM are one-sided: they test one party and treat the other as the residual claimant. The profit split is two-sided.

What the Guidelines say for intangibles

The Guidelines are unusually direct here. The methods most likely to prove useful in matters involving transfers of intangibles are the CUP method and the transactional profit split, with valuation techniques as useful tools (6.145).

Three considerations:

One-sided methods are generally not reliable for directly valuing intangibles (6.141). They may be used indirectly — valuing some functions and deriving a residual for the intangibles — but care is needed to ensure all contributing functions, assets and risks are properly identified (6.141). Importantly, this is not a prohibition on one-sided methods wherever an intangible is present. Where the tested party does not use unique and valuable intangibles and reliable comparables exist, CUP, resale price, cost plus and TNMM remain perfectly appropriate, and the general guidance in Chapters I–III can suffice (6.205). The question is always whether the tested party’s own intangibles are unique and valuable (6.206). A limited-risk distributor using the group brand under licence is still testable by TNMM.

Cost-based approaches are generally discouraged. There is rarely any correlation between the cost of developing an intangible and its value once developed (6.142). Replacement-cost approaches have limited valid application — internal software systems, non-unique intangibles — and raise serious problems for market-facing intangibles, because they capture neither first-mover advantage nor the value of excluding competitors, and are generally unreliable for partially developed intangibles (6.143).

Rules of thumb cannot evidence an arm’s length result — including, expressly, any rule-of-thumb apportionment of income between licensor and licensee (6.144; 2.10). The “25% rule” and its relatives are not evidence.

When the profit split is the right answer

The profit split’s main strength is that it works where both parties make unique and valuable contributions, since in that case there will be no reliable comparables for the transaction as a whole and independents would likely have priced in proportion to their contributions (2.119). It also suits highly integrated operations where a one-sided method would not be appropriate (2.120), and offers flexibility where both parties face high uncertainty (2.121).

For intangibles specifically, it may be the most appropriate method for a transfer of fully developed intangibles where no reliable comparables can be identified (2.132; 6.152).

Where profit-splitting factors are used, asset-based factors suit cases with a strong correlation between assets and value creation (2.179); cost-based factors, such as marketing or R&D spend, suit caseswhere relative expense correlates with relative value — but not where the parties contribute different valuable intangibles, unless costs can be risk-weighted to give a reliable measure of relative value (2.181).

The comparability factors that actually matter for intangibles

If comparables are asserted, these must be worked through (6.117–6.127).

Factor	Why it moves value
Exclusivity (6.118)	Exclusive rights let the holder exclude competitors and confer market power. Non-exclusive rights generally do not.
Extent and duration of legal protection (6.119)	Two otherwise comparable patents are not equivalent if one expires in a year and the other in ten. Know-how protection differs in nature and duration from patent protection.
Geographic scope (6.120)	A global grant may be worth considerably more than a single-country grant — depending on the product and the markets.
Useful life (6.121–6.122)	Affected by legal protection, technological change and new product development. Note that an intangible forming the base for ongoing R&D may have a useful life extending beyond the current product generation.
Stage of development(6.123–6.124)	Established commercial viability is generally more valuable than unproven potential. For partially developed intangibles, assess the likelihood that further development leads to commercially significant benefits.
Rights to enhancements, revisions and updates(6.125–6.126)	Often the difference between a short-term and a long-term advantage. Also relevant: whether the transferee may use the intangible as a platform for developing new intangibles.
Expectation of future benefit (6.127)	The consequence of all the above, and the factor the parties would actually have bargained over.

Where no reliable comparables exist, the analysis turns to the parties’ functions, assets and risks; the business reasons for the transaction; each party’s perspective and the options realistically available to it; the competitive advantage the intangibles confer, especially relative profitability; expected future economic benefits; and other factors such as local market features, location savings, assembled workforce and group synergies (6.139).

Section 2 — Valuation

When valuation techniques are appropriate

Where reliable comparable uncontrolled transactions are not available, valuation techniques applied with due regard to the Guidelines, the facts, and sound valuation practice can be useful tools (6.156). Techniques estimating the discounted value of projected future cash flows over the intangible’s remaining life can be particularly useful when properly applied and — whether applied within one of the five methods or as a standalone tool — may prove more reliable than any other transfer pricing method, particularly where reliable comparable uncontrolled transactions do not exist (6.157; 6.162).

Valuation should generally be tested from the perspectives of both parties, with the arm’s length price falling somewhere within the range between the transferor’s and the transferee’s present values (6.157).

The central weakness: sensitivity

Estimates produced by these techniques are volatile. Small changes to the discount rate, the growth rate or the assumed useful life can produce large differences in value, and the volatility compounds when several assumptions move together (6.158). Reliability depends heavily on the quality of the underlying assumptions and the judgement exercised in setting them (6.159).

The Guidelines therefore expect taxpayers to:

explicitly set out every relevant assumption made in creating the model;

describe the basis for selecting each valuation parameter;

be prepared to defend the reasonableness of both; and

as a matter of good practice, present a sensitivity analysis showing how value changes under alternative assumptions (6.160).

The consistency question

Paragraph 6.161 deserves particular attention. It is reasonable for a tax administration to ask why the assumptions in a transfer pricing valuation differ from those the same taxpayer used in valuations prepared for non-tax purposes. Two examples are given: high discount rates in a transfer pricing analysis where the company routinely uses lower rates when evaluating mergers and acquisitions; and a claimed short useful life where the group’s own business planning projects cash flows well beyond it.

The potential conflict is in the final sentence of that paragraph: valuations used by a group in making operational business decisions may be more reliable than those prepared exclusively for transfer pricing purposes. The practical consequence is that a valuation should be compared against the group’s M&A models, impairment testing, board papers and long-range plans before it is filed.

Discount rates, useful life and terminal value

Some relevant practical considerations:

There is no single correct discount rate, and no presumption in favour of WACC. Neither taxpayers nor tax administrations should assume a WACC-based rate is always appropriate; the specific conditions and risks of the case and the particular cash flows should drive the choice (6.171).

Intangibles may be among the riskiest components of a business, particularly those still in development, and some cash flow streams are inherently more volatile than others — the likelihood of incurring projected R&D spend is generally higher than the likelihood of realising projected revenue (6.172).

Do not double-count risk. Risk can be reflected either in the projections or in the discount rate; care must be taken to avoid discounting for it twice (6.173).

Useful life is a critical assumption in its own right, affected by legal protection, technological change and competition (6.174–6.175). An intangible may keep generating cash flow after legal protection expires, or after the specific products it supported cease to be marketed (6.176).

Financial projctions are the foundation. Their reliability governs the reliability of the whole exercise (6.163).

Section 3 — Hard-to-value intangibles

The issue

There is an inherent information asymmetry between taxpayer and tax administration when an intangible is transferred early in its life. The taxpayer knows what it assumed and why; the administration cannot readily verify whether those assumptions were reasonable, and cannot assess whether the intangible was transferred at under- or over-value until outcomes are known years later (6.191).

The definition

Hard-to-value intangibles (HTVI) are intangibles or rights in intangibles for which, at the time of transfer between associated enterprises: (i) no reliable comparables exist; and (ii) the projections of future cash flows or income, or the assumptions used in valuing them, are highly uncertain — making it difficult to predict the level of ultimate success (6.189).

Transactions involving HTVI commonly display one or more of these features (6.190):

the intangible is only partially developed at transfer;

it is not expected to be exploited commercially for several years;

it does not itself meet the HTVI definition but is integral to developing other intangibles that do;

it is to be exploited in a novel way, with no track record making projections reliable;

it was transferred for a lump sum;

it is used in connection with, or developed under, a cost contribution arrangement.

What is allowed

Tax administrations may consider ex post outcomes as presumptive evidence about the appropriateness of the ex ante pricing arrangements (6.192). That presumption can be limited, and the approach does not apply at all where one of the defined exemptions is met — particularly where the taxpayer produces details of the ex ante projections and demonstrates that any significant difference in outcome arose from unforeseeable developments (6.193–6.194).

Three limits are important, and frequently overlooked by both sides.

The use of ex post evidence must be based on a determination that it is necessary in order to assess the reliability of the information underlying the ex ante pricing (6.192).

Where the administration can confirm that the ex ante information was reliable, adjustments based on ex post profit levels should not be made (6.192).

This must be distinguished from hindsight — taking ex post results for assessment purposes without asking whether the information underlying them could or should reasonably have been known at the time (6.188).

Where the approach does apply, administrations may substitute an alternative pricing structure that independents would have used to manage the uncertainty — milestone payments, running royalties with or without adjustable elements, price adjustment clauses, or a combination (Annex II to Chapter VI, para. 16). Since HTVI are by definition intangibles for which no reliable comparables exist, administrations cannot be expected to substantiate such adjustments by reference to comparable uncontrolled transactions (Annex II, para. 16).

The practical lesson is that the structural answer to HTVI risk is often not a better valuation but a different deal shape. A lump sum represents the valuation dispute at the moment of transfer; a running royalty or milestone structure lets the price follow the outcome, which is frequently what independent parties would have done in any event. Where a lump sum is commercially necessary, agreeing the treatment in advance with the relevant authorities is the cleanest protection.

Section 4 — Where this leads

Three relevant notions.

Method follows the intangible. The question to ask is not which method the group has used before, but whether the tested party’s ownintangibles are unique and valuable. If they are not, and comparables exist, a one-sided method is entirely appropriate. If both parties contribute unique and valuable intangibles, no one-sided method will do the work, and the profit split becomes the natural candidate. Cost-based shortcuts and rules of thumb are not evidence.

Valuation is an exercise in defensible assumptions, not in arriving at a number. The volatility of discounted cash flow models means the number itself proves little; what can be defended is the reasoning that produced it. It is important to state every assumption, explain each parameter, present the sensitivity analysis, and reconcile the result against the valuations the group has prepared for its own commercial purposes.

Where value cannot be predicted, the structure should change. The HTVI regime exists because early-stage transfers cannot be verified until outcomes are known. Fixing a lump sum in those circumstances places the entire burden on a projection that nobody can test. Pricing mechanisms that adjust with the outcome answer the problem at its source.

Part 3 completes the series by turning to the documentation that has to explain and support the analysis, and to the considerations that matter most in practice.

For more information: paul.valdivieso@basefirma.com