In the Spring 2011 edition of the Stout Journal, we identified and discussed the “top 10” issues to consider when completing a business enterprise valuation for tax purposes.1 These 10 issues included areas such as transfer pricing, cash pool agreements, discount rates and legal entity ownership of intellectual property. The focus of this article is to build upon that list with emphasis specific to projects requiring the valuation of multiple legal entities within a parent company’s organizational structure (each a subject entity, collectively the subject entities, each subject entity owned by one subject parent company, either directly or indirectly through subsidiaries). This is often typical in international tax reorganizations.2 Tax-driven multi-entity valuation projects present management and its tax advisors an additional set of considerations and issues in the planning, supporting and review of this work. These considerations and issues include matters of uniqueness from subject entity to subject entity,as well as unique information and communication requirements.
1I Nature of Each Subject Entity’s Operations
In business valuations of a single entity for tax purposes, it may be typical to have a subject entity that is a traditional operating business with a sales and marketing function, a manufacturing/production function, and all of the other functions of a full-fledged company, including customer service, accounting, human resources, information technology and legal. However, in international tax reorganizations, it is not atypical to have subject entities that perform only one function, such as a subject entity that is solely dedicated to sales and marketing or to manufacturing. Such situations not only raise the significance of the transfer pricing (see the aforementioned Spring 2011 Stout Journal article), they present technical valuation issues in areas such as valuation methodology selection, identification of public company peers and selection of valuation multiples. Furthermore, risk assessment can become more abstract in international tax reorganizations due to the additional considerations of intercompany transactions, transfer pricing, and the potential for a lack of good market data.
Beyond subject entities with a single functional focus, international tax reorganizations also frequently require valuations of holding companies. Holding companies can present technical valuation issues depending on the complexity of the respective balance sheets, and could also present challenges in reporting; both reporting historical financial results, as well as reporting the valuation conclusions in the report. These reporting challenges are discussed in Factor #8.
2I Functional Currency of Non-Domestic Entities
Business operations and transactions conducted in foreign currencies by subject entities domiciled outside of the U.S. present a number of differences relative to purely domestic operations, transactions, and currency. One of the first tasks is to understand each subject entity’s functional currency; that is, the primary currency used in conducting the entity’s operations. In cases where the functional currency is different than the functional currency of the subject parent company, a follow-up discussion with management may be warranted to understand the degree to which the business of the subject entity is affected by currency translation. In certain instances, there may be reduced currency translation when there are elements of revenues and operating expenses conducted in the same currency as the subject parent company.
Once the functional currency is understood, key components of any business enterprise valuation analysis, including historical financial statement analysis, risk assessment looking forward, and derivation of a cost of capital, can then be properly framed in the context of the functional currency of the subject entity, as opposed to purely the currency the financial information is presented in. To the extent translated historical financial statements are used, it is important to have knowledge of the accounting for currency translation provided for under U.S. accounting standards (the current method or the temporal method).
3I Basis of Forecast Preparation: Top-Down or Bottom-Up Approach
One of the challenges to performing a business valuation in international tax reorganizations is obtaining robust prospective financial information (e.g., a profit & loss multi-year forecast). This is a challenge because management in most cases do not prepare forecasts by legal entity on an ongoing basis, as the overall business is not managed in this way. In such situations, management may need to prepare a forecast for the subject entities for the first time. Using a top-down approach, management may elect to push down the subject parent company’s operating plan to each subject entity. Alternatively, management may elect to start from scratch in developing a forecast for each subject entity.
One other significant consideration regarding the basis of the forecast is foreign currency and the associated impact of inflation. For high inflation countries, their currencies depreciate over time. Management may elect to build a certain level of ongoing inflation into the forecast if prepared on a local currency nominal basis. Alternatively, management may elect to prepare the forecast on a stable currency basis, which factors out the effects of any inflation in the local currency. In either case, adjustments may need to be made by the valuation specialist, depending on the currency that management has specified for the value conclusion, which may depend on the subject tax authorities.
In general, the valuation specialist is well-served by understanding how the forecast of each subject entity relates to the subject parent company’s operating plan(s) and how any foreign currency is captured in the forecast.
4I Working Capital and Capital Expenditures in Forecast
Building off of Factors #1 and #3, depending on the nature of the subject entity, the forecast of working capital and capital expenditures on a relative basis may be very different from one subject entity to another. Working capital requirements may be highest for those subject entities holding product inventory. Working capital may be impacted by intercompany receivables/payables. Intercompany balances should be discussed with management to ascertain the characterization as a normal working capital item, or whether it is a note receivable or financing debt. In either event, the valuation specialist will, in most cases, explicitly assume that all the transfer pricing is on an arm’s-length basis.
Regarding capital expenditures, subject entities that are solely a manufacturer would presumably have a much higher need for capital expenditure spending than an entity engaged in only sales and marketing.
A comparison of the historical financial statements to the forecast should provide a basis to discern that the projections were prepared on a basis consistent with how the subject entity has operated historically, or conversely, should identify any disconnects that might require revisions to the original forecast.
5I Taxation – Country and Subject Entity Specifics
Effective tax rates vary from company to company and, similarly, statutory tax rates vary from country to country. Country to country differences include differences in tax rates as well as what is taxed. While most countries tax a company’s income, some countries may tax both income and gross receipts (e.g., Afghanistan). Additionally, indirect taxes such as the valued added tax (VAT) and goods and services tax (GST) now are in place in approximately 150 countries. Therefore, this is an area where the valuation specialist may need to coordinate with tax specialists (management or their tax advisors) regarding the tax regime over each subject entity. Considerations should be given not only to statutory rates, but also to effective tax rates. A comparison of historical effective tax rates, based on book income, as compared to the statutory rate, can help identify the need to consider the causes of any differences, such as loss carry forwards and other types of tax assets and credits. Loss carry forwards and ot her types of tax assets may be best addressed in the valuation separate and apart from the operating value of the subject entity.
6I Non-Operating & Other Assets/Liabilities
As in any business enterprise valuation, the balance sheet of the subject entity should be analyzed, including consideration of non-operating assets and liabilities that may not be captured in the operating value of the subject entity. An example of this is excess land, which is land not used in the operations of the business, nor planned to be used in the short to intermediate term. In such situations, it is typical to add the fair market value of the land to the operating value of the subject entity to arrive at the total value for the subject entity. In international tax reorganizations, such assets and liabilities may be found on the balance sheet of holding companies and dormant entities. Other assets/liabilities including tax reserves, tax assets, and loan guarantees can be treated similarly to non-operating assets and liabilities in that their value may be best captured separately, rather than inherent in an overall operating value determination.
7I Indicated Negative Equity Value
In international tax reorganizations, subject entities that are holding companies or are dormant are often valued under an Asset Approach. Such entities could have negative book value, which raises a technical issue when the valuation is to be performed on an equity basis: equity value typically cannot be negative. In these cases, the valuation specialist may need to consider whether another entity in the tax reorganization structure has a liability to cover for the negative equity value. This can occur when an explicit loan guaranty has been provided from one subsidiary to another, but can also occur in less obvious situations, such as: 1) dictated by local regulations, 2) reputational reasons to avoid a taint of the subject parent company, or 3) where corporate governance documents legally require another entity in the parent company’s organizational structure to backstop the liabilities of the subject entity.
8I Investment in Subsidiaries
Large multi-national corporations may include several intermediate layers of holding companies before getting to an operating company of a foreign subsidiary. In the context of international tax reorganizations, such layered ownership structures create reporting challenges. The first reporting challenge is a question of method of accounting used for the reporting of historical financial results. One alternative is to report the historical financial information of the subject entity under the consolidated method of accounting, inclusive of the operations of any investment in subsidiaries, with those operations presented on an item-by-item basis. The alternative is to report the historical financial information under the equity method of accounting for any subsidiaries of the subject entity.3 While the equity method of accounting is often associated with the accounting for non-controlling interests (aka minority interests), the equity method can be used to report financial results of a subject entity where the results of any subsidiary of the subject entity, (whether a wholly-owned subsidiary, controlling interest or otherwise), are captured separately in a single line item,4 which does not provide for the item-by-item presentation as under the consolidated basis. Consolidated financial information may be most appropriate when there is not a need to separately value any subsidiaries of the subject entity. Conversely, equity method financial information may be most appropriate when there is a need to separately value subsidiaries of the subject entity (i.e., a need to value separately both the subsidiary, as well as the subsidiary of the subsidiary).
The second reporting challenge is essentially the same challenge as the first—“consolidated method” versus “equity method”—but from the perspective of what is valued separately, and accordingly, reported in the valuation report separately. Under the “consolidated method,” the subject entity is valued and includes the value of any investment in subsidiaries, although the value of the subsidiaries may not be separately broken out. Under the “equity method,” both the subject entity as well as any investments in subsidiaries are valued separately, and reported separately.
For an example, see Table 1 for a hypothetical organizational chart of ABC Company, and Table 2 for a side-by-side comparison of the presentation of the value conclusion of Entity #1 under a “consolidated method,” and under the “equity method.” Assume Entity #1 is a holding company with a balance sheet comprised of cash of $2.4 million, investments in Entity #3 and Entity #4, and equity. Entity #3 and #4 are both operating companies. When valued separately, Entity #3 and #4 have an enterprise value of $100 million and $350 million respectively, and neither entity has any debt.
9I Value of Subject Entities Relative to the Subject Company
Investments in subsidiaries, internal cross-holdings, and other implementation challenges in international tax reorganizations increase the need for reasonableness checks on the value conclusions. One possible reasonableness check is to aggregate the value conclusions for all the subject entities in the international tax reorganization, and compare this aggregate value to the value of the subject parent company on a consolidated basis. Determining the aggregate value of the subject entities can be more complicated than simple addition in cases where management has requested value conclusions to be reported under the “consolidated method”. In such cases, a valuation waterfall and an up-to-date legal entity organization chart may be necessary to appropriately aggregate the values of each subject entity.
Once the value conclusions of the subject entities have been more appropriately aggregated, the value of the subject parent company on a consolidated basis may then be determined. For public companies, this is often relatively straightforward using the subject parent company’s public market capitalization. For private companies, this might require a separate analysis or ultimately be determined to be infeasible under certain circumstances. In such cases, alternative reasonableness checks may be explored.
With the aggregate value of the subject entities and the value of the subject parent company determined, the relative value can be compared to certain other relative comparisons between the two entities, such as comparisons of earnings before interest, taxes, depreciation, and amortization, revenues, total assets, and number of employees. Adjustments for differing growth and profitability expectations and size, as well as numerous other factors, should all be factored into any relative analysis.
10I Valuation Date versus Reorganization Transaction Date
For large international tax reorganizations, both the valuation analysis and management’s use of the analysis in the reorganization can span an extended period of time. Over the period of time from commencing the valuation on through to execution of the reorganization, the underlying businesses may change, the tax regime may change, and various other changes may occur that impact the proposed international tax reorganization. One way to accommodate the need for a timely valuation analysis is to request a bring-down valuation opinion to follow the original opinion. A bring-down valuation opinion addresses two primary concerns, both of which focus on what has changed since the original valuation opinion: 1) significant changes in the financial results and outlook of the subject entities, and 2) significant changes in market conditions over the subject entities.
This “top 10” list, while not exhaustive, should serve as a strong resource to management and its tax advisors in planning, supporting, and reviewing tax-driven valuation projects that require multiple legal entities to be valued (for example, international tax reorganizations). When management and its tax advisors understand the key valuation factors and their supporting role in addressing such factors, the valuation analysis should be more thorough, well-reasoned, and more carefully documented than otherwise; and the project should be executed in a more efficient process. Ultimately, this should lead to an easier review process by the subject tax authorities, and thereby reduce the potential for any tax investigations and controversy.
John C. Schumacher
1 Jay Wachowicz, Michelle Brower and Andrew Robinson, “Tax Reporting: 10 Issues to Consider When Valuing a Legal Entity,” Stout Journal, Spring 2011 Edition (accessed August 1, 2013).
2 The need for the valuations of multiple legal entities can also be common in other areas of tax, including legal entity purchase price allocations for tax compliance purposes in in merger and acquisition (M&A) transactions.
3 The equity method is sometimes referred to as one-line consolidation, as the investment in subsidiaries is captured in one line item on the balance sheet and one line item on the income statement.
4 Thus, the financial results of the subject entity can be separated from the results of any subsidiaries.