With the enactment of the Trump tax reform, a historically well-discussed but less substantive transfer pricing issue has come to the forefront. This issue has already induced objections as the Organisation for Economic Co-operation and Development (“OECD”) BEPS issuances on intangibles was being debated and issued. This issue pertains to the goodwill that is created when U.S. multinationals (“MNEs”) acquire foreign companies, and then subsequently desire to transfer those acquired entities’ intellectual property (“IP”) to their IP center or centers. As part of the IP transfer, the goodwill and going concern that is implicit in the acquisition—generally as part of a purchase price allocation (“PPA”) valuation for accounting purposes—is often regarded by tax authorities (and in part by the OECD) as being a part of the transferred intangible asset(s), in whole or in part. The goodwill, as such, per foreign tax authorities needs to be transferred with the readily definable intangibles like technology, know-how, patents, or tradenames.
The Trump tax reform has redefined “goodwill” and “going concern” broadly, and its definition is now more in line with the OECD’s goodwill and going concern definition. Since the OECD’s issuance of the BEPS Articles, particularly those pertaining to intangibles and business restructurings, there have been several transfer pricing court cases outside of the United States in which little, if any, of the goodwill that is part of an acquisition is attributed and allocated to the discrete intangible assets transferred. By contrast, at least one recent case actually attributed all of the goodwill to the intangibles transferred. Some of this confusion pertains to the unclear definition of goodwill.
The OECD’s and Trump tax reform’s open-ended definition of goodwill has serious implications for tax directors and their companies, including: (1) adding difficulty and less certainty to valuing the transferred IP and (2) adding difficulty to coordinating agreement on the elimination of double tax between governments. This article will briefly discuss the U.S. and OECD definitions of goodwill and going concern. It will also highlight, thereafter, what functions, assets, and risks (“FAR”) could potentially be deemed a part of the goodwill and going concern of the acquired entity and what should not be part of the acquired entity’s “assets”. Finally, this article will briefly review two court cases in foreign countries which have started the process of redefining goodwill per the OECD definition in the post-BEPS era.
OECD and U.S. Definitions of Goodwill and Going Concern
Regarding the U.S. goodwill/going concern definition, under Trump’s Tax Cuts and Jobs Act workforce in place, goodwill (both foreign and domestic), and going concern value are intangible property within the meaning of Section 936(h)(3)(B), as is the residual category of ‘any similar item’ the value of which is not attributable to tangible property or the services of an individual. The OECD defines goodwill/going concern as “…sometimes described as a representation of the future economic benefits associated with business assets that are not individually identified and separately recognized. In still other contexts goodwill is referred to as the expectation of future trade from existing customers. The term going concern value is sometimes referred to as the value of the assembled assets of an operating business over and above the sum of the separate values of the individual assets. It is generally recognized that goodwill and going concern value cannot be segregated or transferred separately from other business assets.”1
The OECD notes the difficulties of defining goodwill as a unique intangible by stating: “The absence of a single precise definition of goodwill makes it essential for taxpayers and tax administrations to describe specifically relevant intangibles in connection with a transfer pricing analysis, and to consider whether independent enterprises would provide compensation for such intangibles in comparable circumstances.”2
Functions, Assets, and Risks (“FAR”)
One of the critical issues in the OECD Guidelines is that it does not define what elements are a part of the goodwill/going concern value. We note that the goodwill/going concern value has resulted from an accounting valuation assessment, in which intangible assets are very strictly defined.By contrast, the U.S. and OECD both recognize that for transfer pricing purposes, there may be many additional intangible assets or even tangible FAR that need to be valued.
To delineate this point, let us take an example of an early stage start-up entity which is still in the process of developing its technology. The example company’s personnel are primarily located in Israel, though it has a small U.S. subsidiary in which one person is employed whose job is to seek additional funds for the company and seek potential future business development opportunities (though we note that there are none at present as the technology is not yet commercially developed). By chance, a U.S. MNE (acquirer) decides to pay in a competitive bid a hefty sum of money to acquire the Israeli start-up. The PPA’s forecasts include substantive sales and marketing activities (which we note did not exist in the acquired Israeli entity), heavy continued R&D activities, and significant future sales growth and profits. Further, the PPA also finds that only 20 percent of the acquisition price is attributable to the technology, with the remaining 80 percent attributed to goodwill.
The “goodwill/going concern” is now an issue that must be addressed if the “know-how” IP is to be transferred from Israel to the acquirer’s IP center. Is all this goodwill/going concern (i.e., the 80%) a part of the acquired intangible? Per the OECD Guidelines’ goodwill/going concern definition, a transfer pricing analysis must “…describe specifically relevant intangibles in connection with a transfer pricing analysis.” Based on this simplified example, it is possible to note a variety of elements inherent in the goodwill/going concern that are not intangibles, including:
- The Israeli entity’s workforce and its future R&D work;
- The Israeli subsidiary’s business development activities;
- A control premium;
- A premium specific to the competitive bid (known in the industry as “winner’s curse”);
- The acquirer’s future sales and marketing activities (the Israeli entity had none prior to acquisition);
- The acquirer’s future R&D work;
- Synergies pertaining to the acquisition brought to the deal by the acquirer; and
- Continued funding of the IP by the acquirer (which replaces future potential VC funding for the Israeli entity on a standalone basis).
We note that all these items are effectively part of the OECD’s FAR, and per a transfer pricing analysis, they all must be accounted for. Some of these items however, were not part of the acquired start-up.
Further, previous articles on goodwill/going concern written by experienced transfer pricing economists note elements not delineated above that could be part of a FAR analysis, such as executive hubris (known as the Pollyanna principle) and strategic management. Neither the OECD Guidelines nor the U.S.’s new definition of goodwill/going concern provide any guidance on segregation of the above elements of the PPA’s deemed goodwill/going concern.3 Herein lies the issue with valuing the IP and getting the tax authorities involved to agree that these portions of the goodwill/going concern were not transferred (and the quantum of such FAR).
Based on the above, a transfer pricing analyst’s assessment would almost certainly need to deduct price routine returns for sales, marketing activities, and R&D activities from the acquisition; functions that are clearly inherent in the PPA’s forecasts. There are several additional points regarding the analyst’s assessment that should be noted:
The acquired Israeli entity did not have any sales and marketing function, so the function becomes an “external” value attributed to the U.S. MNE.
The goodwill/going concern element cannot be attributed to the Israeli entity’s other business assets, as it did not have such an asset.
There is clearly a control premium and/or winner’s curse value in the acquisition price, and this element is also external to the Israeli entity’s business assets.
There could also be synergies that the U.S. MNE brings to the table.
The entire discussion herein assumes that the analysis being performed is based on the acquisition price, otherwise known in the U.S. regulations as the Acquisition Price Method (“APM”) and in the OECD Guidelines falls under the Comparable Uncontrolled Price (“CUP”) method. The choice of method is not being discussed herein, but simply noted that this, too, will become an issue as it has in many other transfer pricing cases.
Post-BEPS Court Cases
Recent tax court decisions in the post-BEPS era are now attempting to deal with the above issues, but there is no clear consensus. In Israel Tax Authority vs. GTEKO Ltd. (acquired by Microsoft), a case on a business restructuring/intangible transfer, the court ruled (in June 2017) that much of the goodwill was a transferred intangible, though the court noted there had been a valid argument for a control premium which would have been “outside of the box” (i.e., excluded from the IP value). Neither side argued that there was a control premium, so the issue was not decided upon. By contrast, the court denied the validity of synergies as being part of the transaction and thus deducted from the acquisition price as the taxpayer could not prove its synergies were unique among its competitors. Note this “unique among competitors” criterion is not referenced in the OECD Guidelines, but rather was a criterion created by the judge himself.
In the case Netherland vs. A BV (October 2017), a Dutch parent company had provided services to foreign subsidiaries on a cost-plus basis. The parent received compensation when a business restructuring transferred its HQ and strategic functions to Switzerland. The Dutch Tax Authorities concluded that this compensation was not enough and that the parent continued to perform strategic functions for the group. The taxpayer’s assessment that there be no residual value attributed to a foreign transfer of headquarters and strategic functions as these activities continued to be compensated for on a cost-plus basis, was accepted by the lower court.
It will probably take several years until sufficient regulatory and judicial clarity becomes available on what portion of goodwill/going concern value is transferred with IP and how such value should be quantified. As the ink has not yet dried from the BEPS work (with the OECD continuing to issue updated guidance), the recent U.S. tax reform brings more uncertainty to MNEs operating in a shifting international tax landscape. Presumably, tax authorities around the world will deal with the issue differently, leaving taxpayers potentially exposed to double taxation.
Economics Partners, a Ryan Company
1 OECD Guidelines Chapter VI A 4.6.27
2 Ibid A 4.6.29
3 We also note that for transfer pricing purposes, the actual starting goodwill would potentially need to be recomputed based on the transfer pricing expert’s assessment of what intangibles actually existed in the acquired Israeli entity, and what those intangibles’ values are. Such values will not necessarily be those computed by the PPA work. As noted in the OECD Guidelines, “valuations of intangibles contained in purchase price allocations performed for accounting purposes are not determinative for transfer pricing purposes and should be utilized in a transfer pricing analysis with caution and careful consideration of the underlying assumptions."