IP Issues Confronting Knowledge-Based Companies

Thursday, May 1, 2008 - 00:00

Intangible assets or intellectual property ("IP") - commonly classified in various categories1 - play a significant role in corporate competitiveness and performance in our knowledge-based economy. They could yield its owner a competitive advantage in affording higher sales growth, lower cost, higher profit and shield it for a while against competition by erecting barriers to entry.

Intangibles could be created through internal R&D, obtained through joint ventures or licensing agreements and very often via mergers and acquisitions ("M&A"). Intangible assets and goodwill constituted2 74% of the average purchase price of acquired companies in 2003, with intangibles accounting for 22% and goodwill for 52%. Our estimates of the share of intangibles in total assets3 show that the endowment in intangibles is the highest among software companies and lowest in financial services industry companies, with some exceptions.

U.S. private firms currently invest at least $500 billion and perhaps more than $1 trillion annually in intangibles4 , suggesting that the capital stock of intangibles may have a market value of $5 trillion. The share of intangibles in the aggregate economy has grown rapidly and doubled between 1973 and 19935 .

The growth of multinational companies and in the knowledge-driven economy has led to changes in accounting reporting systems to reflect the enhanced role of IP and the efforts to harmonize the standards followed by companies in the U.S. and EU. In 2001, FASB published its FAS 141 (Business Combinations) and FAS 142 (Goodwill and Other Intangibles) to account for IP in M&As6 . In March 2004, the International Financial Reporting Standard for Business Combination 3 ("IFRS 3") was issued requiring companies to report the value of intangibles acquired in mergers and acquisitions.

FASB and IFRS require the purchase price allocation of acquired assets to the tangible and intangible assets and their recording on the balance sheet at fair value. Intangible assets are either amortized over their useful life, assigned indefinite lives or amortized subject to an annual impairment test, whereas goodwill is not amortized. Instead, it is treated as having an indefinite life and is reviewed for impairments once a year or more frequently if an apparent impairment occurred.

Valuation of intangibles is highly significant for accounting and transactional purposes. The accounting standards require companies to value intangible assets that were acquired, perform purchase price allocation and conduct annual impairment reviews. IP's growing significance in business activities and the proliferation of M&As, alliances and licensing activities enhanced the need for the valuation of IP.

The issue of how to value intangibles remains a serious challenge, particularly when transactions involve transfer pricing. Valuation requires familiarity of accounting and tax regulations, knowledge of valuation theory and considerable experience. It could utilize several methods, including the Market Approach, the Income Approach, and the Cost Approach.

The remaining sections of this article will review the various definitions of intangibles and how they are accounted for specifically in M&As, examine the treatment of intangibles for tax purposes in transfer pricing application and review the main valuation methodologies.

Definitions Of Intangible Assets

The definitions of intangible assets and intellectual property are quite broad, the definitions used for accounting and tax purposes do not fully converge and the latter is still in flux. The concept of intangible assets and intellectual properties are often interchangeable; the latter is generally classified in five categories7 , including such items as trademarks, software, industrial design and trade secrets.

According to the FASB8 , "An intangible asset shall be recognized as an asset apart from goodwill if it arises from contractual or other legal rights [or] it is capable of being separated or divided from the acquired entity and sold, transferred, licensed, rented, or exchanged ... For purposes of this Statement, an assembled workforce shall not be recognized as an intangible asset apart from goodwill."

Appendix A of FAS 141 defines intangibles in five groups:

Marketing-related intangible assets, such as trademarks and trade names

Customer-related intangible assets, such as customer lists

Artistic-related intangible assets

Contract-based intangible assets

Technology-based intangible assets

For U.S. transfer pricing purposes, Treasury Regulations Section 1.482-4(b) defines an intangible as an asset with substantial value "independent of the services of any individual" and as comprising any of the following six categories:

Patents, inventions, formulae, processes, designs, patterns or know-how

Copyrights and literary, musical or artistic compositions

Trademarks, trade names or brand names

Franchises, licenses or contracts

Methods, programs, systems, procedures, campaigns, surveys, studies, forecasts, estimates, customer lists or technical data

Other "similar" items - an item is considered "similar" if it derives its value not from "physical attributes," but from its "intellectual content or other intangible properties"

Transfer-pricing regulations imply that intangible property is commercially transferable, and they distinguish between legally protected intangibles, where the legal owner is generally considered the owner for transfer-pricing purposes. For IP that is not legally protected, the developer of the intangible is deemed the owner.

The IRS Coordinated Issue Paper (CIP) on Cost Sharing Arrangements and Buy-in Adjustments9 expanded the definition of intangible assets for which a buy-in payment is required. The Revenue Service maintains that goodwill and going concern value, workforce in place and business synergies, which are not defined as intangibles by Treasury Regulations Section 936(h)(3) or Section 1.482-4 and are not applicable for Treasury Regulations Section 1.367(d), should be treated as intangible assets for application of Treasury Regulations Section 1.482-7, Cost Sharing Arrangements ("CSA").

Accounting For Intangibles

The accounting reporting systems have increased attention to the management of intangible assets by companies in the U.S. and worldwide. Since 2001, FAS 141 and FAS 142 (and most recently IFRS3) account for IP in M&As, but not for internally developed IP.

Historically, goodwill has been primarily defined in residual terms as the price paid in excess of a firm's tangible assets, but FAS 141 and FAS 142 revised the manner by which goodwill is treated in M&As. FAS 141 requires the acquirer to allocate the purchase price paid for the target to all assets and to recognize in the acquirer's balance sheet intangible assets apart from goodwill. The purchase price is allocated first to cash and cash equivalents, then to inventory and any remaining value is allocated to the intangible assets.

On December 4, 2007, FASB issued FAS 141 revised that requires an acquirer to account for the acquisition of assets and assumption of liabilities at fair value, instead of the previously applied cost allocation process. FAS 142 applies to those assets following their acquisition and requires that goodwill and identifiable intangible assets not be amortized on a formulary approach, but be reviewed for possible value impairment annually or more frequently. If the FMV of the assets becomes less than the carrying value of the asset and has occurred, the asset is written down.

Intangible Property And Transfer Pricing

Intercompany transactions in intangible assets is addressed by Treasury Regulations Section 1.482-4 and Section 1.482-7, which require that taxpayers determine the arm's length transfer price of intangibles provided to affiliates abroad. The transfer price covers outright sales or licensing of intangibles or buy-in and cost-sharing arrangements. In such transactions, valuations are critical in producing arm's length results with correct tax implications.

On September 27, 2007, the IRS issued a CIP on buy-in payments for intangible assets made available in a CSA. Determining such payments is subject to valuation methodologies specified by the CIP, which include the Income Method and the Acquisition Price Method. In addition, the definition of intangibles was broadened.

Valuation Methodologies, Most Appropriate Approaches

Both an art and a science, valuation is an interdisciplinary study drawing upon law, economics, accounting and investment. Valuation of intangibles is required for a variety of applications, including transactional purposes, for allocation of purchase price and for impairment analysis. Valuation could utilize different methods - depending on the type of intangible, the industry, the market in which the intangibles are used and the availability of data. The most frequently used valuation methods are the Market Approach, the Income Approach and the Cost Approach.10

The Market Approach values intangible assets by reference to comparable transactions in similar assets and markets. Although this approach could in theory provide the best evidence of fair values, data is rarely available, and it could be difficult to ensure comparability.

The Income Approach values intangible assets on the basis of their expected economic benefits to the asset owner either through an increase in revenues - thanks to excess profit or premium pricing power - or a reduction in costs. The income approach applies the net present value ("NPV") to capitalize the stream of net income or free cash flows expected by the owner of the intangible. This approach (a) requires the identification and measurement of the cash flow (or earnings) attributable to the intangible assets, or specific assets, and capitalization of those cash flows or earnings; and (b) deriving the appropriate discount rate commensurate with the risk profile of the flows. Typically, utilization of intangible assets might be associated with higher risk than the exploration of tangibles. Within this approach, the relief from royalty method is quite popular.

The relief from royalty method derives the value of an IP by estimating the price a business would pay for the use of an intangible asset if it did not own the asset or the cost savings of not having to pay a royalty. The methodology requires the application of an appropriate royalty rate and cost of capital, and derivation of expected FCFs or earnings. The value of the asset corresponds to the present value of the royalty stream that the business is saving thanks to ownership or the cost attributed to licensing from others.

The Cost Approach values intangible assets by assessing the development or replacement cost of the asset.

Closing Comments

Intangible assets are highly significant for companies, accounting for approximately two-thirds of the total assets of U.S. public companies and three-fourths of the purchase price of acquired companies. Accounting standards in the U.S. and EU require companies to value and report acquired intangible assets. The proliferation of multinationals and intercompany transactions has placed a new focus on intangible assets and their proper definition and valuation. Valuation and transfer pricing professionals could assist in addressing some of the concerns relating to accounting and tax issues involving intangible assets.

1 Reilly, Robert F., and Schweihs, Robert P., Valuing Intangible Assets , McGraw-Hill, 1999, P. 19-20; Smith, Gordon V., and Parr, Russell L., Valuation of Intellectual Property and Intangible Assets , 2nd Ed., Wiley, 1994

2 Hadjiloucas, Tony and Winter, Richard PWC, Special Focus Chapter: Reporting the Value of Acquired Intangible Assets, Building and Enforcing Intellectual Property Value 2005

3 A useful approach to estimate the value of intangibles of a firm is by application of the following model: Q= (1-1/(MV/BV), where Q measures the share of intangibles out of the total market value, and MV is market value of equity and BV is book value.

4 Nakamura, Leonard I. The Rise In Gross Private Investment In Intangible Assets Since 1978 , Federal Reserve Bank Of Philadelphia, June 2003; and What Is The U.S. Gross Investment In Intangibles? (At Least) One Trillion Dollars A Year! Working Paper No. 01-15, Federal Reserve Bank Of Philadelphia, October 2001.

5 Contractor, Farok J., Editor , Valuation of Intangible Assets in Global Operations, Quorum Books, 2001

6 On Dec 4, 2007, FASB issued FAS Statement 141 revised by improving reporting and creating consistency in the accounting and financial reporting of business combinations in coordination with the International Accounting Standards Board (IASB).

7 Reilly, Robert F., and Schweihs, Robert P., Valuing Intangible Assets, McGraw-Hill, 1999, P. 20-22, Marketing related, such as trademarks and service marks; Technology related, such as certain types of patents; Artistic-related, such as literary and musical copyrights; Data processing-related, such as computer software copyrights and computer chip masks and masters; Engineering-related, such as industrial designs and trade secrets".

8 Financial Accounting Standards Board, Statement of Financial Accounting Standards No. 141, Business Combinations, June 2001, Par. 39 & Appendix A

9 IRS, Coordinated Issue Paper, LMSB-04-0907-62, September 27 , 2007.

10 Blair, Roger D., and Thomas F. Cotter , Intellectual Property: Economic and Legal Dimensions of Rights and Remedies, Cambridge University Press, 2005; Boer, Peter F., The Valuation of Technology: Business and Financial Issues in R&D, Wiley, 1999; Cohen, Jeffrey A. , Intangible Assets: Valuation and Economic Benefit, Wiley, 2005: Mard, Michael J., Hitchner, James R., Hyden, Steven D., Zyla, Mark L., Valuation for Financial Reporting, Wiley 2002; Markus, Keith E. , Intellectual Property Rights in the Global Economy, Institute for International Economics, 2000.

Harvey Poniachek, Ph.D., CVA, is Director of Valuation Services at RSM McGladrey in New York and Adjunct Professor of Finance at CUNY Baruch and Pace University.

Please email the author at harvey.poniachek@rsmi.com with questions about this article.