Implied Discount rate - NABE

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Agenda• Background• Measuring discount rates• Income method under final cost sharing regulations• 2011 Temporary and proposed cost sharing regulations• Discount rates used in different forms of payment3

Background• Discount rates reflect/measure the risk associated with an expected cashflow.• Cost sharing regulations, and in particular the income method, increasedthe focus of discount rates in transfer pricing.• The key question is how to identify and measure the appropriate discountto use with a given forecasted income. Important to understand:– the forecasts: do forecasts factor in the risk of failure, or reflect expected resultsif successful?– the forecast horizon: Financial results in the distant future are more uncertainthan those in the near future– the risk level of income to be discounted: Residual profits are more uncertainthan routine profits• Many concepts/formulas to measure discount rates, e.g. WACC, WARA,the IRR4

Different Discount Rates• Weighted Average Cost of Capital (WACC)– Theoretical measure of the cost of acquiring capital based on the capital assetpricing method or other techniques – Widely used in finance• Internal Rate of Return (IRR)– Measures the rate of return on a cash flow earned from of a certain level ofinvestment• Weighted Average Return on Assets (WARA)– Reconciles total return of enterprise to rates of return on specific asset classes• Observed interest rates (e.g. borrowing rates, venture capitalist rates, etc..)5

Risk vs. Expected ReturnThe least liquid (riskiest) class of business assets require the highest returnNon-liquidNarrow MarketIntangibleAssetsEquityFinancedTangibleAssetsWorking CapitalDebtFinancedLiquidVersatileCashLowInvestment Return RequirementsHigh6

Example – Reconciling Discount RatesThe Business Portfolio of Assets—Risk and Return CharacteristicsAsset Type Value WeightRequiredReturnDollarReturnWeightedReturnTangible AssetsWorking Capital 200 8.1% 3.5% 7 0.28%Fixed Assets 475 19.2% 5.0% 24 0.96%Other Assets 50 2.0% 5.5% 3 0.11%Intangible AssetsTrade Name 250 10.1% 15.0% 38 1.52%Customer Relationships 1000 40.4% 16.0% 160 6.46%Goodwill 500 20.2% 20.0% 100 4.04%Total Business 2475 100.0% 331WARA 13.37% 13.37%• The 13% WARA calculated above should approximate the company’s WACC8

Income Method• Under the income method, the PCT payments are calculated as follows:(PV of cash flows from the cost sharing alternative) – (PV of cash flows from thelicensing alternative)• The final regulations emphasize further that the financial projections used in applyingthe income method are “necessarily the same” in comparing the cost sharingalternative to the licensing alternative• Consequently, differences between the discount rates must reflect only thedifferences between the obligations undertaken under the two alternatives• The effective result is:– PCT Payor is left with a return for its “routine” functions and risk plus an appropriateexpected rate of return for its risky investment in intangible investment.– PCT Payee captures all future “economic profit” over and above the return for routinefunctions/risks• The PCT payments are primarily a function of:– Discount rate spread between the licensing and cost sharing alternatives– Projections regarding long-horizon expected profitability9

The Income Method illustrated:PCT payor’s perspectiveProjected ProfitsBeforeIP DevelopmentCostsA B CProjected ProfitsUnder CostSharingAlternativeProjected ProfitsUnder LicensingAlternativeYear 1 0 -20 0Year 2 100 100 40Total 100 80 40PCTPayment(=PV of A –PV of B)Discount Rates 17% 8%Present Values $55.26 $34.29 $21.66Alternative Discount Rates 15% 12%Present Values $58.22 $31.89 $26.3310

Financial Projections and Discount Rates• Financial projections for the licensing and cost sharing alternatives are interrelated– Projections are the same except for licensing payments under licensingalternative, and cost contributions and PCT payments under cost sharingalternative– Thus, income method builds off of single probability-weighted financialprojections associated with the CSA activity• Discount rates for licensing and cost sharing alternatives are interrelated; anydifference is solely due to– (1) incremental risk associated with cost contributions undertaken in cost sharingalternative, and– (2) risk associated with different payment forms• Are management long-term forecasts (if they even exist) true long-term probabilityweightedfinancial projections accounting for the risk of failure?– Potential use of venture capital discount rates as an alternative to “haircut” onforecasts.11

The 2011 temporary regulations• The preamble to the 2011 temporary regulations states that the IRS and Treasury“are aware” that some taxpayers have applied the income method by using anunrealistically low discount rate for the licensing alternative and an unrealisticallyhigh discount rate for the cost sharing alternative– The high discount rate spread between the two alternatives results in a lowerPCT Payment• The final regulations state that discount rate for the cost sharing alternative and thelicensing alternative are “closely related” because both are derived from the “singleprobability-weighted financial projections. That any differences in discount ratesshould only reflect:Incremental risk associated with developing cost shared intangibles and makingR&D cost contributions versus making licensing paymentsPayment forms of the licensing payments and the PCT payments (e.g., a royaltybased on sale vs. fixed PCT Payments)12

The 2011 temporary regulations: differential incomestream• The 2011 temporary regulations introduce the concept of the “implied discount rate”of the “differential income stream” between the two alternatives– The “differential income stream” is defined as the difference between theundiscounted income streams under the cost sharing and the licensingalternatives (akin to the residual income)– The “implied discount rate” of the “differential income stream” is the rate thatyields an equivalent value of the PCT as determined under the income methodusing different discount rates for the two alternatives– The implied discount rate should be consistent with reliable direct evidence– WACC for uncontrolled companies developing intangibles similar to the costshared intangibles is suggested as a basis to determine the appropriate implieddiscount rate– The implied discount rate provides a basis for assessing whether the incomemethod has been reasonably applied13

The 2011 proposed regulations: differential incomestream• The 2011 proposed regulations carry the concept of the temporary regulationsfurther by proposing to use market evidence of discount rates directly in a newlyspecified application of the income method――Determine the PCT obligation as the present discounted value of the differentialincome stream using an appropriate discount rate directly determined usingmarket evidenceWACC for uncontrolled companies developing intangibles similar to the costshared intangibles is suggested as a basis to determine a discount rateappropriate for the differential income stream• Both the temporary and the proposed regulations are designed to provide specificguidance on the selection of different discount rates to prevent what the IRSperceives as inappropriate application of discount rate differentials to produceunderstated PCT values14

The “Implied Discount rate”: in practice• In practice, for a majority of cases it may be extremely difficult to observe directmarket evidence of the “implied discount rate”• An alternative is to derive the discount rate of the non-routine profit stream of thecost shared intangibles from the overall return.• Consider the equality: Operating profit = routine return + non-routine profit• Expressing in present value terms:NPV(Operating profit, R OI ) = NPV(routine return, R R ) + NPV(non-routine return, R NR )where,R OI = discount rate for operating profit (e.g., WACC)R R = discount rate for routine returnR NR = discount rate for non-routine profit• One approach to derive the discount rate of routine return may be to use the WACCsof routine comparables.• Re-arranging terms:NPV(non-routine return, R NR ) = NPV(Operating profit, R OI ) - NPV(routine return, R R )• Thus, implied discount rate for the non-routine profit stream may be derived as ratethat solves the above equality (through iteration)• It is still prudent to perform a sanity check to determine that the derived discount rateis reasonable given market evidence15

Discount rates illustrationDiscount Rate forresidual profitA B CRoutine Profits Total Profits DifferenceYear 1 0 -20Year 2 40 100Total 40 80DResidual Profits= (B – A)-206040Discount Rates 12% 15%Present Values $31.89 $58.22 $26.3317.67%$26.33Benchmarked by WACCsof comparablesAppropriate discount rate fortotal profit, e.g., WACCDerived rate that equates the presentvalue in D to the amount in CIncome method calculation in final regulationsIncome method calculation inproposed regulations16

2011 Temporary Regulations - Example 8• Two cost sharing participants; one has a PCT contribution which is valued usingIncome Method• The discount rates for the cost sharing alternative is estimated at 20 percent andthat for the licensing alternative is estimated at 10 percent resulting in a $146 millionPCT• The Commissioner computes an “implied discount rate” by equating the net presentvalue of the “differential income stream” to the PCT value of $146 million, whichresulted in a “implied discount rate” of 34.4 percent• By analyzing comparable uncontrolled companies, the Commissioner concluded thata reasonable “implied discount rate” based on market evidence is about 16 percent• Thus the taxpayer’s analysis was deemed unreasonable and an adjustment wasissued17

2011 Proposed Regulations - Example 9• Two cost sharing participants; one has a PCT contribution which is valued usingIncome Method• The discount rates for the cost sharing alternative is estimated at 15 percent andthat for the licensing alternative is estimated at 13 percent resulting in a $464 millionPCT• The Commissioner has additional data on discount rates for comparable companies• Based on available data, the Commissioner determines that an appropriate range for“implied discount rate” is 15 percent or 17 percent• The PCT values are calculated as $446 million and $ 501 million, with 17 percentand 15 percent discount rates, respectively• Since the taxpayer’s estimated PCT value lies between this range, it was deemedreasonable and no further adjustments issued18

Forms of Payment and Discount Rates• PCT payment may take the form of one-time lump sum payment, fixed installmentpayment or contingent payment• The final cost sharing regulations recognizes the difference in risk profilesassociated with different payment forms• A contingent payment based on sales will necessitate a different discount rate thanone that is based on profits or a fixed installment payment.• Discount rates for operating profit stream may be estimated by the WACC or theWARA.How does one estimate a discount rate for the revenue stream?• Finance theory can provide a useful framework to analyze the interrelationshipsbetween discount rates applicable to different cash flows to help estimate anapplicable discount rate for revenue/sales19

Forms of Payment and Discount Rate – Discount rateof revenue stream• Starting with a simple equality that holds every periodOperating Income = Revenue – Cost, where Cost = Fixed Costs + Variable Costs• Expressed in net present value terms over the relevant time horizon:where,NPV(Operating income, R OI ) = NPV(Revenue, R Rev ) – NPV(VC, R VC ) - NPV(FC,R FC )R OI = discount rate for Operating ProfitR Rev = discount rate for RevenueR VC = discount rate for Variable CostsR FC = discount rate for Fixed Costs• Finance literature suggest that revenue and variable costs have a high degree ofcovariance and thus they can be expected to have similar volatility/variability *• Thus, re-arranging terms:NPV(Operating income, R OI ) = NPV(Revenue - VC, R Rev ) - NPV(FC, R FC )* For example, see Brealey, R.A., and Myers, S.C; Principles of Corporate Finance 5th ed.; (1996) McGraw Hill Companies.20

Discount rate of revenue stream – Numerical exampleDiscount Rate forrevenue streamA B C D = A – B – C C + DE = A – BRevenuesVariableCostsFixedCostsOperatingIncomeRevenue –Variable CostsYear 1 $100 $50 $20 $30Year 2 $90 $45 $10 $35Year 3 $120 $60 $25 $35$50$45$60DiscountRatesPresentValues5% 12%$49.71 $79.60 $129.319%$129.31Appropriate discount rate forfixed costs, e.g., yields onlong-term corporate bondsAppropriate discount ratefor operating income, e.g.,WACCDerived discount rate forrevenues that equates E to thesum of C and D in present valueterms22