Valuing a Research and development project

Valuing a Research and development project is an example of a special project in IFRS 3. The reporting entity acquires a research and development (R&D) project in a business combination. The entity does not intend to complete the project.

If completed, the project would compete with one of its own projects (to provide the next generation of the entity’s commercialized technology). Instead, the entity intends to hold (i.e., to lock up) the project to prevent its competitors from obtaining access to the technology. In doing this, the project is expected to provide defensive value, principally by improving the prospects for the entity’s own competing technology.

To measure the fair value of the project at initial recognition, the highest and best use of the project would be determined on the basis of its use by market participants.

For example:

  1. The highest and best use of the R&D project would be to continue development if market participants would continue to develop the project and that use would maximize the value of the group of assets or of assets and liabilities in which the project would be used (i.e., the asset would be used in combination with other assets or with other assets and liabilities). That might be the case if market participants do not have similar technology, either in development or already commercialized. The fair value of the project would then be measured on the basis of the price that would be received in a current transaction to sell the project, assuming that the R&D would be used with its complementary assets and the associated liabilities and that those assets and liabilities would be available to market participants.
  2. The highest and best use of the R&D project would be to cease development if, for competitive reasons, market participants would lock up the project and that use would maximize the value of the group of assets or of assets and liabilities in which the project would be used. That might be the case if market participants have technology in a more advanced stage of development that would compete with the project if completed and the project would be expected to improve the prospects for their own competing technology if locked up. The fair value of the project would be measured on the basis of the price that would be received in a current transaction to sell the project, assuming that the R&D would be used (i.e., locked up) with its complementary assets and the associated liabilities and that those assets and liabilities would be available to market participants.
  3. The highest and best use of the R&D project would be to cease development if market participants would discontinue its development. That might be the case if the project is not expected to provide a market rate of return if completed and would not otherwise provide defensive value if locked up. The fair value of the project would be measured on the basis of the price that would be received in a current transaction to sell the project on its own (which might be zero).

Valuation of intangible assets

The valuation of intangible assets is a complex, but nevertheless well established topic, in theory and practice. This statement is valid not only for transfer pricing specialists, but also other stakeholders such as advisors (e.g. valuers in corporate finance, accounting experts and public financial auditors). Valuing a Research and development project

Unfortunately, it is rather easy to get lost in a host of technical details or to simply reduce the determination of arm’ s length prices first and foremost to the application of sophisticated valuation methods. Instead, it is crucial to remind oneself, at times, that a meaningful valuation for transfer pricing purposes must be built upon answers to the questions dealt with in the two preceding sections, namely: Valuing a Research and development project

  • What is the subject of the discussion, i.e. which intangibles are relevant to the transaction under consideration? This refers to identification of intangibles.
  • Who owns the intangibles in question? Who is entitled to remuneration based on facts and circumstances, i.e. on a legal or contractual basis, or, alternatively, based on relevant (service) contributions with regard to the intangibles 1? This refers to ownership clarification.

Only then is the next step to resolve the “adequacy question” as outlined in the below figure, namely the determination of an arm’ s length value or price attributable to the intangibles and/or (potentially) supporting services under consideration within the framework of the relevant inter company transaction(s).

The valuation process

Valuation is a process, as shown in the below figure. It is not merely the calculation of one or more numerical results out of an array of data, based on a more or less sophisticated algorithm in an Excel spreadsheet. Rather, the transparent conduct and documentation of the entire process and valuation assumptions strengthen not only the acceptance of the results thereof among stakeholders inside the company, but also their consistent validation in a tax audit. Valuing a Research and development project

The valuation process is always a subjective exercise, because the main determinants of the value of economic goods are their desirability and utility. 39These subjective factors may suggest a two-sided valuation, in order to capture (potentially different) ideas of transaction parties2 about an adequate value of the object of the valuation. This is in line with the arm’ s length principle. Valuing a Research and development project

This two-sided valuation is established by reference to the hypothetical arm’ s length test, if necessary3. Moreover, valuation standards provide general orientation with regard to a proper conduct of the valuation process and also with regard to the valuation of selected intangible assets. Valuing a Research and development project

Different value concepts may underlie a valuation, such as fair market value, a liquidation value in bankruptcy cases, a negotiation value in market transactions or an infringement value in IP litigation cases. Value concepts refer to different situations and define certain framework conditions for the valuation process. They also reflect the general purposefulness of valuations.

Moreover, different valuer roles4 adopted by certain stakeholders involved will have an impact on the valuation process. Finally, valuation must be distinguished from measurement. Even though the value of an intangible asset or other goods may be given (colloquially, measured) in monetary units, measurement refers to directly or indirectly observable factors, which are not measurable on a monetary scale, such as the measurement of purchase probability of test customers in a buyer-intention survey, or the establishment of a utility function in a joint measurement framework. Valuing a Research and development project

Costs, value and price are three terms which are often used in a valuation context. Costs are considered to be a poor indicator only of the value of intangibles. An obvious example is funds spent on R&D projects, which will not always automatically turn into commercial success stories that create value for the company. And at the same time, the increased knowledge derived from failed projects is unfortunately difficult to measure. Valuing a Research and development project

However, costs will be reflected in the price of goods, for example, as distinct price elements or as a minimum price threshold from a seller’ s perspective, between independent as well as affiliated parties. Consequently, costs will definitely be an important decision criterion in pricing, especially with regard to the timing of the valuation of intangibles for transfer pricing purposes.

Value can be reflected in a certain price, but not necessarily in a “linear relation fashion”. This is because price will also be affected by market- or transaction-related aspects, such as relative scarcity, demand and subjective need fulfilment or economies of scale in production, which may be directly or indirectly linked to the intangible(s) relevant to the transaction under consideration.Input factors Valuing a Research and development project

In preparation for a valuation process, it is necessary to clarify which quantitative and qualitative data and information are available, and whether it would be required to obtain missing or incomplete information, at what cost and how long this would take. It may be better to proceed with a set of reasonable assumptions or alternative “workarounds”, rather than to insist on the accuracy or completeness of certain sets of data going into the valuation. Therefore, information availability will also have an impact on the choice of the applicable valuation methods.

Through the range of data and information used for valuation purposes and also via applicable valuation methods, several significant influencing factors can be built into the valuation process, for example, the (remaining) useful life of the intangible subject to valuation; uncertainty and risk; inflation; tax rates; the company’ s capital structure; and the time value of money of expected cash flows. Valuing a Research and development project

A double counting of relevant factors5 or their inconsistent consideration6 may be deemed avoidable technical pitfalls in the valuation process.

The transformation of qualitative information, which has potentially been established in a comparability analysis, into quantitative data is another challenge, for example, the function and risk profile of transaction parties involved, contractual conditions7 or the scope of protection assigned to certain intangibles from a timing (duration), geographical and content perspective. Valuing a Research and development project

In order to make such information and data available to monetary valuation, assumptions will have to be made and, again, this reflects the subjective character of valuations.

Last but not least, the point in time when a valuation is conducted is a decisive factor. This is valid with regard to the question as to the stage in the life cycle of an intangible at which valuation and pricing are actually performed. Valuing a Research and development project

And it has a relevant impact on the value and/or the amount of an arm’ s length price, as the development of a patent or brand will give rise to costs right from the start, while profits (or profit potential) may materialize (or not) only at a later point in the life cycle of the intangibles. Valuing a Research and development project

In this context, cost-oriented valuation methods may deliver more reasonable indications of the value of an intangible at an earlier point in its life cycle, in comparison to highly sophisticated discounted cash flow methods, which may become more reliable and relevant for valuation purposes at a later point in time, when certain turnover linked to the intangible subject to valuation has already been realized, or can be expected with higher likelihood. Valuing a Research and development project

Methods available

In addition to the well-known transfer pricing methods described in detail in chapter II of the OECD Guidelines, a broad spectrum of methods for the valuation of intangibles is available in literature and business practice. Valuing a Research and development project

Although these methods were most likely not developed for transfer pricing purposes, they may well be applicable from a mere “technical perspective” while duly taking into account certain transfer pricing-relevant framework conditions, such as the requirement for two-sided valuations or an adequate reflection of specific information obtained in a comparability analysis.

As there is no one-size-fits-all method available for all cases of valuation of intangibles in a transfer pricing context, it does not seem reasonable at this point to provide prescriptive recommendations for or against certain valuation methods a priori. Valuing a Research and development project

Rather, the selection of a valuation method in a given case will depend on the type of intangible or IP that is subject to valuation; the respective data and information available; the valuation purpose and timing relative to the intangible’ s lifecycle; and the application and acceptance of the method in common business practice and/or in court.

In other words, the choice will depend on the given situational framework conditions. The method chosen is then applied several times in the process, to adequately reflect a two-sided valuation. It also makes sense to apply more than one valuation method in order to do plausibility checks of the valuation results obtained.

The figure below provides an overview over various transfer pricing-relevant valuation methods, which may themselves be categorized into fewer general approaches8 to valuation. Valuing a Research and development project

It is, however, not always possible to unambiguously categorize the methods listed here. Examples are the transactional net margin method (TNMM), comparable profits method or the relief from royalty method, which may also be summed up under the heading of “market-based approaches”, as they rely on market comparables (i.e. profit margins or royalty rates).

Moreover, variants of one “base method” could potentially be attributed to different categories, depending on how the calculation method has been  established in detail9.

The valuation of intangibles and IP is important, particularly with regard to the determination and documentation of arm’ s length royalty rates charged to affiliated companies for their utilization of corporate intangibles and IP. This is effected on the basis of the residual profit split method, as described in the OECD Guidelines.

Additionally, external and internal CUP data are available in this regard for plausibility and consistency checks, as well as for transfer pricing documentation purposes. In individual cases, valuations of self-created or acquired intangibles will be conducted in the case of cross-border IP transfers, which can support the consolidation of the IP ownership structure inside a multinational group. As an example, in these cases the relief from royalty method is often applied. Valuing a Research and development project

Whether the valuation is conducted internally by finance professionals or is supported by external valuation specialists also, will depend on the value and strategic relevance of the transaction in question. And purchase price allocations which can, at the very least, be considered indicative for the value and valuation of intangibles, are rather only seldom available.

After having considered the ownership question, the preceding discussion is meant to provide a practical framework for the determination of an arm’ s length value (and price) for relevant intangibles in inter company transactions. The discussion below addresses (i) current developments at the OECD and UN level, with regard to transfer pricing aspects of intangibles and (ii) the most significant consequences that these developments might entail for companies. Valuing a Research and development project

Valuing a Research and Development Project

The highest and best use of the R&D project would be to cease development if market participants would discontinue its development. That might be the case if the project is not expected to provide a market rate of return if completed and would not otherwise provide defensive value if locked up. The fair value of the project would be measured on the basis of the price that would be received in a current transaction to sell the project on its own (which might be zero). 

Valuing a Research and Development Project

Valuing a Research and Development Project

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Valuing a Research and Development Project

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