Contents - AL-Tax
Contents - AL-Tax Contents - AL-Tax
178 12 Decentralized Ownership of Intellectual Property FS’ projected cash outlays (which should be treated as USP’s expenses),including:– Projected intangibles-creating marketing and promotional expenses;– Projected investments in tangible assets and working capital; and,– Projected cash operating expenses. Projected investments in the further development of USP’s IT platform thatwould otherwise be borne by FS; All site operations expenditures allocable to FS’ territory; and, The estimated tax costs of operating in this manner (given the likelihood thatUSP would be deemed to have permanent establishments in FS’ markets).In computing the net present value associated with the “self-develop and license”option, USP’s projected after-tax free cash flows should incorporate the followingcomponents: FS’ projected net revenues, multiplied by an arm’s length royalty rate for rightsto use USP’s successively refined platform in international markets (which wouldconstitute USP’s licensing income); Arm’s length fees payable by FS to USP for site operations support; Projected investments in the further development of USP’s IT platform thatwould otherwise be borne by FS; and, The estimated tax costs on licensing and services fee income earned by USP.In computing the net present value associated with a JV arrangement, one wouldpresumably assume that the (hypothetical) JV agreement would be identical to theactual JV agreements between USP and third parties. Projected free cash flows intotal (half of which would accrue to USP) should reflect: The JV company’s projected revenues and cash outlays (as defined above) in FS’territory; Projected investments in the further development of USP’s IT platform thatwould otherwise be borne by FS; Site operations expenses allocable to FS; Projected interest costs; and, Projected tax costs.Each option should be discounted at a different rate, reflective of the associatedrisks. The option that yields the highest net present value can be used to establishthe minimum buy-in payment that FS should make to USP under the cost-sharingarrangement. USP should be indifferent between (a) the cost-sharing option, and(b) the “self-develop and exploit internally” option, the “self-develop and license”option or the JV option (depending on which has the highest net present value). Thenet present value of the cost-sharing option should incorporate FS’ buy-in payment,its ongoing fees for site operations services rendered, USP’s associated site operationsexpenses, FS’ cost-sharing contributions and USP’s associated tax costs. Thediscount rate applied to projected after-tax free cash flows under the cost-sharing
12.6 Comparison 179option should be lower than the discount rate applied to projected results under theother three scenarios, to reflect USP’s reduced market- and research-related risk.Denoting the buy-in payment as our unknown and equating the two net presentvalues, one can solve for the minimum buy-in payable to USP. USP’s results in itsdomestic market do not need to be incorporated into this analysis, inasmuch as theyremain the same across all of our scenarios.FS must also be willing to pay the derived buy-in fee on an arm’s length basis,considering its feasible alternatives. Such alternatives include licensing another platformthat satisfies its lesser functionality requirements and obtaining site operationssupport from a third party vendor, or relying on one of the IT platforms to whichit obtained rights through the acquisition of competitors (and continuing to fundupgrades of this platform). If FS would earn a negative or zero net present value bypaying the minimum buy-in fee computed above, it would not be willing to enterinto the cost-sharing arrangement on a genuinely arm’s length basis.12.5.2 Market Capitalization MethodThe market capitalization method could in principle be used in this instance as well.FS was established just prior to entering into the joint venture agreement with USP,which we have recharacterized as a cost-sharing agreement for analytical purposes.USP was a public company at this time. Therefore, USP’s average market capitalization,increased by its liabilities and reduced by (a) the value of its tangibleassets (primarily servers), (b) the value of its user community and brand identity,and (c) its goodwill and going concern value, constitutes the value of its IT platform.Under the market capitalization method, FS should pay a percentage of this residualvalue to USP, equal to its anticipated relative benefits from exploitation of the ITplatform.The difficulty here lies in determining reliable fair market values for USP’s usercommunity, brand identity and goodwill/going concern. Goodwill and going concernvalue are almost always determined as a residual. However, under the marketcapitalization method, the IT platform value is determined as a residual, necessitatingthat one explicitly value goodwill/going concern. It is unclear how one woulddo so in a reliable way.12.6 ComparisonOur analysis of this case under the current transfer pricing regime is based on theresidual profit split method. As discussed at length in Chapter 3, this methodologyis fraught with weaknesses, chief among them being the assumption that expenditureson the development of intangible assets, on the one hand, and the value ofsuch assets, on the other, bear any necessary relationship to one another. All of theconceptual and practical problems associated with the comparable profits method,
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12.6 Comparison 179option should be lower than the discount rate applied to projected results under theother three scenarios, to reflect USP’s reduced market- and research-related risk.Denoting the buy-in payment as our unknown and equating the two net presentvalues, one can solve for the minimum buy-in payable to USP. USP’s results in itsdomestic market do not need to be incorporated into this analysis, inasmuch as theyremain the same across all of our scenarios.FS must also be willing to pay the derived buy-in fee on an arm’s length basis,considering its feasible alternatives. Such alternatives include licensing another platformthat satisfies its lesser functionality requirements and obtaining site operationssupport from a third party vendor, or relying on one of the IT platforms to whichit obtained rights through the acquisition of competitors (and continuing to fundupgrades of this platform). If FS would earn a negative or zero net present value bypaying the minimum buy-in fee computed above, it would not be willing to enterinto the cost-sharing arrangement on a genuinely arm’s length basis.12.5.2 Market Capitalization MethodThe market capitalization method could in principle be used in this instance as well.FS was established just prior to entering into the joint venture agreement with USP,which we have recharacterized as a cost-sharing agreement for analytical purposes.USP was a public company at this time. Therefore, USP’s average market capitalization,increased by its liabilities and reduced by (a) the value of its tangibleassets (primarily servers), (b) the value of its user community and brand identity,and (c) its goodwill and going concern value, constitutes the value of its IT platform.Under the market capitalization method, FS should pay a percentage of this residualvalue to USP, equal to its anticipated relative benefits from exploitation of the ITplatform.The difficulty here lies in determining reliable fair market values for USP’s usercommunity, brand identity and goodwill/going concern. Goodwill and going concernvalue are almost always determined as a residual. However, under the marketcapitalization method, the IT platform value is determined as a residual, necessitatingthat one explicitly value goodwill/going concern. It is unclear how one woulddo so in a reliable way.12.6 ComparisonOur analysis of this case under the current transfer pricing regime is based on theresidual profit split method. As discussed at length in Chapter 3, this methodologyis fraught with weaknesses, chief among them being the assumption that expenditureson the development of intangible assets, on the one hand, and the value ofsuch assets, on the other, bear any necessary relationship to one another. All of theconceptual and practical problems associated with the comparable profits method,
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