HTVI Transaction Analysis

The article analyses a transfer of an organised part of an enterprise (OPE) whose key asset is an in-development IP portfolio that qualifies as a hard-to-value intangible (HTVI). It situates the case within the OECD Transfer Pricing Guidelines, covering the identification of intangibles and risks, functional/comparability and DEMPE analyses, and the ex-ante vs. ex-post price comparison that drives HTVI classification and potential tax authority intervention.

we introduced the concept of Hard-To-Value Intangible in the article “HTVI in Transfer Pricing.” A closer look at this issue reveals how challenging it is to establish transaction terms that reflect market conditions, particularly when dealing with intangible assets.

Transfer Pricing Guidelines (TPG 6.4) specify the upcoming steps in this process:

• Identifying intangible assets and associated risks in contracts.
• Conducting a functional and comparability analysis.
• Supplement the analysis by assessing the parties’ actual conduct, focusing on the functions performed, assets utilised, and risks borne, including control over key functions and economically significant risks.
• Identifying the “legal” owner(s) as defined by TP (TPG 6.36–6.46);
• DEMPE analysis.

Classifying the transaction as HTVI involves comparing the planned transfer price, based on information available at the time of valuation (ex-ante price), with the actual price derived from real data (ex-post price). It also depends on the tax authority’s actions, which are influenced by whether the difference between ex-ante and ex-post prices exceeds 20% of the ex-ante price.

The tax authority can question the assumption of applying ex-post results:

• If the ex-ante assumptions considered the possibility of a specific event happening and the extent of its impact (scenarios included in the price),
• If the actual events and the impact level were unpredictable,
• If, according to market practice, a transaction under review may involve adjusting the amount or changing the payment structure to accommodate the high level of uncertainty on the transaction date.

Example of a transfer transaction involving an Organised Part of an Enterprise (OPE) that contains intangible assets meeting the HTVI criteria.

• Company X in the XY group developed innovative solutions that transformed key aspects of the production technology used by subsidiaries Y and X to manufacture a product offered in the B2B market (process innovation).
• The XY group decided to establish a special-purpose entity, INNOV, which will be responsible for advancing this technical solution to a market-ready state to implement the innovation protected by the IP Portfolio in subsidiaries Y and X, and potentially commercialise the IP Portfolio on an external market (subject to a positive assessment of changes in the XY group’s competitive position).
• For this purpose, an organised part of company X’s enterprise, including a team of designers, tangible assets, and the IP Portfolio, was contributed to INNOV in exchange for a 30% equity stake in the company. The parent company in the XY group acquired the remaining share (70%) in exchange for a cash contribution.
• Achieving market readiness of technical solutions protected by the IP Portfolio requires additional research (approximately 1.5 years), including on the industrial installation of company Y, and if the expected results are achieved (reduction of costs of key processes, shortening of operational times, improvement of product quality), financing of extended patent protection in selected territories and consideration of the feasibility of commercialising the IP Portfolio.

The transaction involves a two-step process:

1. Contribution of Company X’s original capital assets to INNOVO – the original capital assets must be valued at market value.
2. Conclusion of multiple resource use agreements, pending the development of the R&D project.
   • An agreement allowing INNOV to use Y’s industrial line for R&D purposes for up to 1.5 years,
   • To establish an agreement for the creative contribution and participation of X and Y in future patents, provided that these companies actively engage their human capital in R&D, development, and implementation.
   • INNOVO’s licensing agreements with companies X and Y, and with unrelated entities, for the use of patents protecting the new technology, following completion of the R&D project.

Should the described OPE transfer transaction be analysed within the context of the HTVI definition? Which elements of the transaction could lead to the increased tax risk associated with the transaction classified as HTVI? What steps should we take to reduce this tax risk?

The timing of transaction no. 1 is the primary basis for classifying this transaction as HTVI.

The R&D project for process innovation, developed on the company X industrial line, remains unfinished and underfunded as of the transaction date. A larger research team and a more universal approach, not limited solely to the specific features of industrial line X, are needed to develop this technical solution. The test results and measurements to date do not yet provide a reliable basis for estimating the future technical parameters of the industrial line following the implementation of the innovation.

The risk analysis of continuing the R&D project, depending on the completion of transaction no. 1, shows that:

• The fulfilment of the project objectives depends on the occurrence of two independent events with a probability between 30% and 50%.
• Many cost parameters exhibit significant variability.
• Anomalies in product prices and the costs of specific essential resources have historically occurred.
• There is a risk of delaying project completion by approximately 1.5 years due to delays in obtaining required certifications and approvals. • There is a significant level of uncertainty regarding the possibility of further commercialisation of the invention (know-how transfer, licenses).

When valuing the OPE and determining the transaction price, the future involvement of entities X, Y, and the XY group in the project development should also be considered, including the resources these entities will contribute, the risks they will assume, and the functions they will perform.

Valuing the OPE for Transaction No. 1

When examining the issue from the viewpoint of valuation standards and practices, we see only a few options:

1. The DCF (discounted cash flow) method in the income approach is the most universal and flexible. They say, “paper doesn’t hurt and can handle any scenario,” but another good saying is “be professionally wrong.”
2. The CTM (comparative transaction method) in the market approach—although useful—can be difficult to apply because the OPE’s key asset is an R&D project still in development. This method requires access to information on M&A financial transactions—such as acquisitions of comparable entities or net assets—found in commercial databases. 
3. The adjusted net asset (ASN) method in the cost approach, also known as the asset method, entails a detailed valuation of each component of the OCP.

Typically, two or three valuation methods are used in combination when valuing businesses, OPEs, and equity instruments, given their distinct characteristics, measurement errors, and limitations. Using more methods helps establish a range of values within which the market value is likely to fall.

Note that, after the contribution, INNOVO’s accounting records and balance sheet will need to separately record the values of the acquired tangible and intangible assets. For this purpose, regardless of the valuation method used for the OPE as a whole, the so-called IP Portfolio, which includes the intangible assets subject to a joint transfer of ownership, is additionally valued.

Regrettably, we had to reject the simple approach of valuing the OPE using the ASN method and estimating the market value of the IP Portfolio using the replacement cost approach. It was because Company X had already filed patent applications that confirmed the development of innovative solutions in the current R&D project. Therefore, if we use the ASN method to value the OCP, the valuation of the IP Portfolio should be performed using a variation of the DCF method, such as the RNPV (Risk-Adjusted Net Present Value) method.

Meeting the HTVI definition requires a stochastic model to value the IP Portfolio. This type of model will enable consideration of:

• expected variability of technical and financial parameters (represented as random variables in the financial model),
• the reliable likelihood of significant events and their outcomes,
• the unknown uncertainty of unknown events.

As a result, we will obtain a range of valuation outcomes, including the market value of the IP Portfolio. Analysing how sensitive the valuation result is to the simultaneous volatility of multiple independent or correlated variables helps identify key risk areas associated with using the valuation for transaction purposes. It enables the adoption of potential measures to mitigate this risk, such as structuring the transaction. We should thoroughly document the valuation process in the transfer pricing documentation. Also, we discussed the use of stochastic models for IP Portfolio valuation in simpler situations in the article “Implementing Risk in Valuation – An Introduction.”

Is there another solution to this problem?

We could try applying the real options approach to valuing the IP Portfolio. The underlying asset would be the target technical solution and its future capacity to create additional value.