Contents - AL-Tax
Contents - AL-Tax Contents - AL-Tax
4.3 Required Return on Debt and Equity Capital 59do not exist. However, companies periodically require valuations of their assetsas a whole, or of individual assets. For example, valuations may be necessary forpurposes of: Tax reporting (e.g., corporate restructuring for tax purposes, requiring the intercompanysale of individual group members or purchase price allocations); Financial reporting (e.g., testing for goodwill impairment); and, Contemplated transactions (e.g., fairness opinions, acquisitions and divestitures,going-private transactions, etc.).To the extent that valuations prepared for these purposes do not reflect intercompanypricing, they may be useful in a transfer pricing context under the proposedrequired return method. Valuations of individual group members undertaken in connectionwith contemplated transactions with unaffiliated companies should be giventhe greatest weight, inasmuch as they will reflect arm’s length assessments. (Competentappraisers should adjust for non-arm’s length pricing between the subjectcompany and the other group members with which it transacts.) Valuations done forfinancial reporting purposes may be useful, but only if they do not reflect intercompanypricing. Because goodwill impairment testing is required on an annual basisfor financial statement purposes, a more detailed discussion of this requirement, andits potential applicability for transfer pricing purposes, is warranted.In June 2001, the Financial Accounting Standards Board (FASB) released itsStatement of Financial Accounting Standards No. 142, relating to the treatment ofgoodwill and other intangible assets. Statement of Financial Accounting StandardsNo. 142 disallows the amortization of goodwill for financial reporting purposes,requiring instead that public companies record goodwill at its fair market value. Assuch, firms must test goodwill for impairment on an annual basis at the level ofindividual “reporting units.”Goodwill is defined as “[t]he excess of the fair value of a reporting unit over theamounts assigned to its assets and liabilities ...” 9 Testing for goodwill impairmenttherefore necessitates that firms establish the fair market value of their reportingunits, either by reference to quoted market prices (where feasible) or by means ofother valuation techniques, including the “present value technique.” The FASB’sStatement of Financial Accounting Standards No. 142 also sanctions the use ofearnings multiples “... when the fair value of an entity that has comparable operationsand economic characteristics is observable and the relevant multiples of thecomparable are known.” 10 Reporting units are defined consistently with Statementof Financial Accounting Standards No. 131, Disclosures About Segments of an9 See Statement of Financial Accounting Standards No. 142, Financial Accounting StandardsBoard: Norwalk, CT, June 2001, para. 21.10 The FASB’s Statement of Financial Accounting Standards No. 142 also states that the use ofmultiples “would not be appropriate in situations in which the operations or activities of an entityfor which the multiples are known are not of a comparable nature, scope, or size as the reportingunit for which fair value is being estimated.” Ibid, para. 25.
60 4 Some Alternative Approaches to Transfer PricingEnterprise and Related Information. Companies are permitted to equate reportingunits with operating segments or “one level below.”Where reporting units are equated with operating segments, valuations for goodwillimpairment testing will be unhelpful, because they are likely to require a prioradjustment to transfer pricing. Because the valuation is one step along the analyticalroad to establishing arm’s length transfer prices, the exercise becomes circular inthis event.In view of the difficulties in valuing entity-specific equity capital in a reasonablyreliable way, some means of reducing compliance costs under the proposedrequired return method is quite important. As previously noted, taxing authoritiescould mutually agree to accept a baseline valuation done at multi-year intervals,absent significant changes in the business, with informed estimates of percentageincreases or decreases in value in the interim. The latter should be related to percentagechanges in the value of publicly traded companies in the same or similarlines of business.Alternatively, tax authorities might agree that, for transfer pricing purposes, individualgroup members’ equity capital can be valued by reference to standard valuationmultiples that do not have earnings (net income, EBITDA, cash flow, etc.) astheir denominator. For example, tax authorities might establish a convention that theequity value of a subsidiary operating in Country X that sells exclusively to thirdparties will be determined by reference to the median price-to-sales ratio for all publiclytraded firms operating in the same, comparatively narrowly defined industry inCountry X. If the tested party operates in more than one line of business, a weightedaverage multiple would have to be used.4.3.2 Cost of DebtIndividual members of a controlled group may borrow from a centralized internaltreasury facility. Taking as given the amount, maturity date, seniority andother features of intercompany indebtedness, one can estimate an individualgroup member’s arm’s length, market-determined cost of debt as of a givendate by: Estimating the group member’s credit rating (by reference to financial ratiosdesigned to measure its ability to pay interest and repay principal on a timelybasis); 11 Assembling a sample of publicly held firms that have similar credit ratings, andhave issued publicly traded debt with similar maturities and other characteristics;and,11 Standardized templates that can be used to estimate credit ratings using simple accounting dataare available, and generally produce reasonably accurate results.
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4.3 Required Return on Debt and Equity Capital 59do not exist. However, companies periodically require valuations of their assetsas a whole, or of individual assets. For example, valuations may be necessary forpurposes of: <strong>Tax</strong> reporting (e.g., corporate restructuring for tax purposes, requiring the intercompanysale of individual group members or purchase price allocations); Financial reporting (e.g., testing for goodwill impairment); and, Contemplated transactions (e.g., fairness opinions, acquisitions and divestitures,going-private transactions, etc.).To the extent that valuations prepared for these purposes do not reflect intercompanypricing, they may be useful in a transfer pricing context under the proposedrequired return method. Valuations of individual group members undertaken in connectionwith contemplated transactions with unaffiliated companies should be giventhe greatest weight, inasmuch as they will reflect arm’s length assessments. (Competentappraisers should adjust for non-arm’s length pricing between the subjectcompany and the other group members with which it transacts.) Valuations done forfinancial reporting purposes may be useful, but only if they do not reflect intercompanypricing. Because goodwill impairment testing is required on an annual basisfor financial statement purposes, a more detailed discussion of this requirement, andits potential applicability for transfer pricing purposes, is warranted.In June 2001, the Financial Accounting Standards Board (FASB) released itsStatement of Financial Accounting Standards No. 142, relating to the treatment ofgoodwill and other intangible assets. Statement of Financial Accounting StandardsNo. 142 disallows the amortization of goodwill for financial reporting purposes,requiring instead that public companies record goodwill at its fair market value. Assuch, firms must test goodwill for impairment on an annual basis at the level ofindividual “reporting units.”Goodwill is defined as “[t]he excess of the fair value of a reporting unit over theamounts assigned to its assets and liabilities ...” 9 Testing for goodwill impairmenttherefore necessitates that firms establish the fair market value of their reportingunits, either by reference to quoted market prices (where feasible) or by means ofother valuation techniques, including the “present value technique.” The FASB’sStatement of Financial Accounting Standards No. 142 also sanctions the use ofearnings multiples “... when the fair value of an entity that has comparable operationsand economic characteristics is observable and the relevant multiples of thecomparable are known.” 10 Reporting units are defined consistently with Statementof Financial Accounting Standards No. 131, Disclosures About Segments of an9 See Statement of Financial Accounting Standards No. 142, Financial Accounting StandardsBoard: Norwalk, CT, June 2001, para. 21.10 The FASB’s Statement of Financial Accounting Standards No. 142 also states that the use ofmultiples “would not be appropriate in situations in which the operations or activities of an entityfor which the multiples are known are not of a comparable nature, scope, or size as the reportingunit for which fair value is being estimated.” Ibid, para. 25.