Please see "10 (More) Issues to Consider When Valuing International Legal Entities" for an additional 10 topics that should be considered carefully when performing a valuation of multiple legal entities within a parent’s organizational structure.
Business valuations are often completed to comply with various tax requirements, including internal restructuring, mergers and acquisitions, gift and estate tax, “C” to “S” corporate conversions, and cancellation of debt analyses. The global tax policy landscape has changed over the past several years with the introduction of the Tax Cuts and Jobs Act of 2017 (TCJA), Global Intangible Low-Taxed Income (GILTI), and Base Erosion and Profit Shifting (BEPS), among others, and the landscape will inevitably continue to evolve for some time. Now that more countries are adopting uniform taxation standards, multinationals are reassessing their tax strategies and corporate structures in order to attempt to minimize effective tax rates, improve accessibility of cash, and reduce uncertainty when making business decisions.
Given the impact of the changing regulatory environment, tax-related valuations are becoming increasingly prevalent. Since valuation is often a critical component in the planning and execution of these initiatives, we have prepared the following list of valuation stumbling blocks that frequently present themselves. Being aware of and appropriately addressing these potential issues at the onset of a valuation engagement will result in a more efficient process and help one stand-up to scrutiny from various taxing authorities.
A critical component in nearly all valuation projects is a projected cash flow stream. Since each geographic region has its own unique economic and industry trends, it is important to consider these local characteristics in deriving or supporting the projected cash flow stream. Specifically, the projected cash flows should consider local growth, inflation, and currency expectations over the long-term, which can vary dramatically from country to country, among other items. Ultimately, it is necessary for the projected financial information utilized in the valuation to be supportable relative to the economic and industry factors affecting the subject entity or entities.
Since legal entity valuations are generally focused on specific legal entities, the discount rate utilized to value these entities should be considered on a stand-alone basis, as it is likely to be different from the parent company’s overall discount rate. Some factors that contribute to differences in the discount rate include company size, industry risk (including unique risks associated with the entity’s unique functional purpose), capital structure, and geographic risk (e.g., financial, economic, and political risk). In regard to geographic risk, investors evaluate investment returns by considering the risk associated with the location of the legal entity’s operations. This becomes increasingly difficult to quantify when the cash flows are derived from a multitude of foreign regions where market data may be limited.
Consistency among the various assumptions utilized throughout a valuation assignment is crucial. One common mistake is calculating a rate of return that is not consistent with the cash flows to which the rate of return is applied in regard to currency and/or risk profile. For example, the forecast may be on a “real” basis (i.e., constant currency without inflation) while the discount rate includes inflation expectations. Another example is matching the tax impact of the projected cash flows and rate of return (i.e., pre-tax versus after-tax basis). As such, it is very important to synchronize the underlying components of each.
Income tax policies, which impact a valuation from the perspectives of both cash flow and rate of return, can vary significantly by specific geography. Local income tax exemption rates, depreciation and amortization deductibility, treatment of net operating loss (NOL) carryforwards, and related factors can vary widely across jurisdictions and can have a meaningful valuation impact.
Multinational organizational charts can often include hundreds of legal entities, frequently with varying ownership stakes and forms of ownership (e.g., common equity, preferred equity certificates, convertible debt). Understanding and accurately modeling the ownership structure of the subject entities is critical. Furthermore, related-party relationships (e.g., parent-to-subsidiary or “sister” entities) can materially impact critical assumptions utilized to derive projected cash flows. For example, a related party entity may own the intellectual property or other intangible assets utilized by the subject entity, intercompany royalty rates may already be embedded into the subject entity’s cash flow, related party transfer pricing may be present, and certain entities may simply be legal entities without any operating activity.
In a legal entity valuation, it is important to consider the fact that intangible assets are often legally owned by a separate legal entity that is specifically designated for intellectual property ownership management. In this instance, a valuation expert needs to investigate legal entity ownership of intangible assets and ensure the valuation analysis reflects such ownership through cash flow apportionment. That is, even though the economic cash flows associated with an intangible asset may be generated by the operations of one entity, the legal owner of the intangible asset needs to be compensated such that the overall value of the intangible asset resides with the entity which owns the intellectual property.
Additionally, fixed asset appraisals are often included in the scope of a legal entity valuation assignment. In order for the fixed asset appraisal to be accurate and hold up to scrutiny from local taxing authorities or other reviewing parties, it is critical for the appraisal to consider and incorporate local market trends and transaction activity (particularly in regard to real property).
Financial statement information utilized as a reference for valuation practitioners is often very complex due to the consolidation of numerous legal entities across various geographic regions. As a result, intercompany accounts frequently appear on both the income statement and the balance sheet. Understanding the nature of these intercompany accounts (e.g., financing (capital) vs. operating (working capital) accounts, interest expense vs. operating expense) and how they should be treated within the context of the valuation assignment is vital. For example, it is common for one legal entity to provide a loan to another legal entity with the entity providing funds recording a note receivable on its balance sheet. Over time, if financial performance declines, the borrowing legal entity may not have the ability to repay the loan, thereby decreasing the probability that the loaning legal entity will be able to collect its receivable.
It is important to analyze the financial condition of the borrowing entity in these scenarios to ensure that there is sufficient economic value supporting the note receivable. In instances in which the borrowing entity does not have the wherewithal to repay the loan, consideration should be given to the legal aspects of the note to determine whether other entities may be responsible for the payment of the loan or if other assets may be attached as collateral before making a downward valuation adjustment to the note to the amount that could be repaid (if any).
In other cases, working capital management may be centralized in one entity within a geographic region, whereby other regional entities may not maintain a “normal” level of working capital consistent with their functional purposes.
Finally, when valuing many legal entities, particular care must be taken to ensure that both sides of transactions are accounted for consistently. If an account is deemed to be a financing-related note receivable for one entity, the corresponding payable must be treated as debt for the borrowing entity. Likewise, working capital-related accounts must be consistent (e.g., equal and offsetting working capital surplus and deficit between two entities).
Multinational businesses must comply with a variety of international transfer pricing laws intended to apportion profits fairly based on each entity’s functional purpose and domicile. Accordingly, it is important to be aware of pre-existing transfer pricing analyses and fully understand how the financial information utilized in the valuation assignment is impacted by transfer pricing (e.g., a management-prepared forecast may not include the same transfer pricing adjustments incorporated in historical statutory statements). This becomes increasingly important when the context of the valuation assignment includes an asset-by-asset segmentation. Specifically, valuations must consider market royalty rates assigned to individual assets (e.g., intellectual property) that were calculated for transfer pricing, cost-plus arrangements, or other transfer pricing policies. For example, in situations where a royalty rate charged for the use of a technology asset is significantly divergent with a market royalty rate charged for comparable technology (based on market observations), an adjustment may be necessary to incorporate the market information when performing the valuation.
Repatriation rules, policies, or restrictions related to the subject entities being valued within a business valuation assignment are also important to understand, since such items could materially impact the cash flow available for distribution (and thus value). Specifically, various repatriation regulations could impact the appropriate tax rate to utilize against future earnings or the amount of restricted cash (i.e., cash that is unable to be distributed to a parent entity or shareholder) within the entity. Moreover, any applicable repatriation regulations could vary depending on other aspects of the valuation assignment, including premise of value, value definition, hypothetical likely buyers, and more.
The highest and best use of an asset or business must be considered when estimating value under the Fair Market Value premise if the subject interest is controlling in nature. In broad terms, highest and best use is determined based on the use of the asset by market participants that maximizes the value of said asset, even if the intended use of the asset by the business is different than a general market participant. For example, in situations in which a business is not generating a sufficient return on its underlying assets, a hypothetical orderly liquidation value may be a more appropriate method to value the business than a going concern value.
Depending on the purpose of the valuation, the appropriate conclusion may be either an asset value (which is generally equal to enterprise value plus current and long-term non-debt liabilities) or an equity value (i.e., enterprise value less total debt). Given the different requirements, it is critical that company management consult its tax and valuation advisors to ensure the output of a valuation analysis is consistent with the respective tax requirements.
Understanding who the regulatory authority and ultimate reviewer of the project will be is critical from a valuation perspective. This item becomes increasingly complex if the valuation will be reviewed by multiple regulatory agencies. Each of these agencies may have its own unique standard of value that will drive critical theoretical assumptions for the analysis such as premise of value, value definitions, and hypothetical vs. market participant buyers.
The appropriate standard of value from a U.S. tax law perspective is “Fair Market Value,” while the standard of value for financial reporting purposes is “Fair Value.” Although there are specific (and often subtle) differences between Fair Market Value and Fair Value standards, often the values of an asset valued under these premises are very similar. However, in certain cases, they may differ materially.
Fair Market Value and Fair Value are two of the most common valuation premises; however, there are several other standards of value that may be appropriate to consider given the circumstances surrounding the valuation analysis, including investment value. Investment value is defined as the value based on a specific investor’s assumptions, which may include revenue enhancement synergies and/or cost synergies upon combination. The generally accepted view is that Fair Market Value should exclude such synergistic benefits. However, courts, in certain situations, have contemplated the available universe of buyers and the potential impact from a valuation perspective. Careful consideration and analysis should be performed with respect to consideration of such factors when determining value.
In preparing a legal entity valuation analysis, care must be given with respect to the factors/issues mentioned above. This list certainly does not capture every possible valuation issue to contend with, but it does reflect several issues that are commonly encountered. The bottom line is that these issues (and others, depending on the facts and circumstances) need to be considered and properly accounted for in order to prepare a valuation analysis that will withstand the scrutiny of regulatory authorities.
A version of this article was previously published in March 2011.