Acquisition premiums and cost sharing analysis
In the world of mergers and acquisitions, it is fairly common to observe a difference between the actual price paid in acquiring a target company and the preacquisition fair value of the company, the acquisition premium. Keith Reams, Lawrence Shanda, Joe Tobin, and Wen-Fang Liu analyse the concept.
A public company that has a preacquisition stock price of $50 per share, but is acquired at $60 per share, obtains a 20% acquisition premium. Similarly, a company that has an estimated preacquisition value of $80 million but is acquired for $100 million, enjoys an acquisition premium of $20 million. Although acquisition premiums are simple to calculate, they can often impact a company's financials in nuanced ways.
The presence of acquisition premiums has various implications for both financial reporting and corporate taxation. This article provides an overview of acquisition premiums from a transfer pricing perspective in the context of a cost sharing analysis.
Acquisition premiums and cost sharing arrangements
When a target company is acquired and some or all of its assets are contributed to a cost sharing arrangement (CSA) between the buyer and its affiliate(s), the acquisition price method as defined in IRS Treas. Reg. §1.482-7(g)(5) can potentially be used to determine the value of the platform contribution transaction (PCT) payment among the CSA participants. In particular, the acquisition price method determines the value of the PCT payment as the amount paid to acquire a target company plus its liabilities minus its tangible assets and other assets that are not contributed to the arrangement. An analysis of the acquisition premium is important in the application of the acquisition price method because an acquisition premium often accounts for a significant part of the acquisition price and thus can have a large impact on determining the value of the PCT payment.
The concept of an acquisition premium is closely related to the "goodwill" concept in financial statement valuations. Goodwill accounting is typically carried out through an analysis of the purchase price allocation, or PPA, which allocates the acquisition price/purchase price to various assets and liabilities acquired in the transaction. The PPA calculates goodwill as the difference between the acquisition price and the fair market value of the tangible assets and identified intangible assets. As such, acquisition premiums arising from synergies may fall within the goodwill bucket. Although allocations or other valuations done for accounting purposes are not conclusive for purposes of the best method analysis in evaluating the arm's-length charge of a PCT, they often provide a useful starting point. With respect to the goodwill from an acquisition, further analysis is generally needed to identify the source and nature of the underlying value drivers and the associated legal ownership and benefits in connection with each of the CSA participants.
Why are there acquisition premiums?
Researchers and practitioners have identified several factors that account for the presence of acquisition premiums. Synergies and control premiums are among the two most commonly identified, and are discussed below.
Synergy refers to the potential additional value gained from combining two companies. Synergies occur when the value from the merger of two companies is greater than the sum of the values that would have been achieved if the organisations had not merged. Synergies may be bifurcated into two categories:
Operational synergies are those synergies that allow companies to reduce their operating costs, increase revenue and growth, or both. An example of operational synergy is achieving economies of scale from buying a customer, a supplier, or a competitor, which allows the combined company to become more cost-efficient and profitable. Revenue growth in new or existing markets may also arise from the combination of two companies through the cross-utilisation of distribution networks, shared customer lists, and/or expanded product offerings.
Financial synergies arise when the benefits of combining two companies come from higher cash flows, a lower cost of borrowing, or a more favorable tax status. A merger of two companies when one company has a large amount of cash or excess borrowing capacity while the other has high-return projects but lacks project funding can result in financial synergies. A profitable company that acquires a company with accumulated net operating losses may be able to use the latter's NOLs to reduce its tax burden.
Control premium refers to the incremental amount an investor will pay to acquire control of a company, typically an amount higher than the company's current market value. The term "control premium" has created some confusion and disagreement among valuation professionals. Some people use the term to represent the overall acquisition premium offered by buyers in taking over a public company, because this premium appears to quantify the value of control. In his analysis of control premium, Nath (2011) distinguished between investment control and management control. He stressed that the mere fact of control does not lead to any specific premium. He explained that because public shareholders have total control over their investment, there is no control premium associated with investment control. Furthermore, management control of a public company resides with the board of directors, and public markets exist to allow investors the opportunity to invest easily in companies without requiring any management skill or management responsibility on the part of the investor. Accordingly, in most cases there is no control premium associated with management control. Cornell (2013) further elaborated that control premiums exist only when the board of directors and management of a public company operate ineffectively and fail to maximise the value of the company, and commented that in the great majority of situations, there are no control premiums and acquisition premiums are the result of other factors such as synergies.
Analysis of IRS Examination's and IRS Office of Chief Counsel's views on acquisition premiums and relevant court cases
IRS Examination and the IRS Office of Chief Counsel have historically opposed taxpayer valuations that use the acquisition price method to allow for carve-outs of the control premium and other acquisition premiums such as synergies of the acquirer. In these groups' view, if such premiums were paid by the US parent and benefit the US parent, then they also benefit the controlled foreign corporation (CFC) when intangibles related to them are contributed to a CSA. IRS Exam and the Office of Chief Counsel have also challenged an argument that is often put forward by taxpayers in support of such carve-outs: that such carve-outs should be allowed if the acquisition premium represents the "synergies of the acquirer" rather than any inherent value in the intangibles being transferred to the CSA (we will refer to this as View SA).
The basic idea behind View SA is that, under the arm's-length standard, the value of the transferred intangibles should be determined without reference to any value the PCT payee (typically the US parent) would be able to add to such intangibles because of its own abilities. Rather, under View SA, the value of such intangibles should be determined by reference to what the US parent would be able to obtain for such intangibles from a midmarket buyer if it had to turn around and sell them on the open market.
IRS Exam and the Office of Chief Counsel have challenged this midmarket approach based on the view that it is inconsistent with their interpretation of the arm's-length standard described in Treas. Reg. §1.482-1(b)(1) (the arm's-length standard). But their interpretation of that regulation has been rejected by both the US Tax Court (see Xilinx v. Comm'r, 125 T.C. 37 (2005)) and the Ninth Circuit Court of Appeals (see Xilinx v. Comm'r, 598 F.3d 1191 (2010)). Accordingly, taxpayers may consider whether View SA might be appropriate under alternative interpretations of the arm's-length standard. Let us take a closer look at what happened in Xilinx to better understand these arguments and how they might apply to the calculation of the acquisition price method.
IRS Examination's and the Office of Chief Counsel's view is based on the idea that the arm's-length standard requires calculation of the PCT payment solely by reference to two amounts – what the controlled seller is willing to accept (given its unique circumstances), and what the controlled buyer is willing to pay (given its unique circumstances). But the Ninth Circuit explicitly rejected this view in the Xilinx appeal:
Section 1.482-1(b)(1) specifies that the true taxable income of controlled parties is calculated based on how parties operating at arm's-length would behave. The language is unequivocal: this arm's-length standard is to be applied in every case. In the context of cost sharing agreements, this rule would require controlled parties to share only those costs uncontrolled parties would share. By implication, costs that uncontrolled parties would not share need not be shared.
This behavioral interpretation of Treas. Reg. §1.482-1(b)(1) (which looks to how uncontrolled parties behave) is at odds with IRS Exam's and Office of Chief Counsel's interpretation of Treas. Reg. §1.482-1(b)(1), because it does not address the behaviour of uncontrolled parties (who, they admitted in the Xilinx litigation, never shared stock option costs); rather, it provides for a construction of value based on a complex econometric analysis of the interaction between the two controlled parties.
The Xilinx concurrence explained that even if this view of Treas. Reg. §1.482-1(b)(1) were theoretically possible, the government did not clearly articulate it in its regulations, so the court need not defer to it:
Although I would not go so far as Xilinx in characterising the Commissioner's interpretation as merely a convenient litigating position, we need not defer to it because he has not clearly articulated his rationale until now. Indeed, I am troubled by the complex, theoretical nature of many of the Commissioner's arguments trying to reconcile the two regulations. Not only does this make it difficult for the court to navigate the regulatory framework, it shows that taxpayers have not been given clear, fair notice of how the regulations will affect them. … These regulations are hopelessly ambiguous and the ambiguity should be resolved in favor of what appears to have been the commonly held understanding of the meaning and purpose of the arm's-length standard prior to this litigation.
Thus, following the Xilinx concurrence, taxpayers might argue that the IRS Office of Chief Counsel should explain and specify its complex interpretation of the arm's-length standard in detailed regulations before requiring compliance with the interpretation. Accordingly, taxpayers might also contend that they are entitled to follow the Ninth Circuit's behavioural interpretation of the arm's length standard, rather than what the Ninth Circuit viewed as the IRS Office of Chief Counsel's complex, unarticulated interpretation.
Assuming that taxpayers may rely on such a behavioural interpretation of the arm's-length standard (at least until such time as IRS Office of Chief Counsel articulates its more complex view of Treas. Reg. §1.482-1(b)(1)), what are the consequences of applying such a behavioural interpretation to the acquisition price method? The behavioural interpretation of the arm's-length standard, when applied to the acquisition premium carve-out issue, could require that the PCT payment from the PCT payor (typically the CFC) to the PCT payee (typically the US parent) be based on what the value of the intangibles would be on the midmarket price in an open market (that is, finding the midmarket price when considering a whole range of possible sellers versus a whole range of possible buyers) rather than on what the PCT payor would pay for them given its unique circumstances. In other words, the PCT payment could be based on the inherent value of the intangibles rather than any value that any specific PCT payor or any specific PCT payee is able to bring to the situation to increase their value. Hence, under this view, the control premium or acquisition premium may be carved out of the acquisition price to arrive at the inherent value of the intangibles.
This result may be especially warranted when the PCT payor has already paid the PCT payee for various items that would create the synergies that must be carved out. This idea was persuasively explained in Chandler and Foley (2010), which demonstrates how the acquisition price method results in double counting (compared to the income method) in situations whereby the PCT payor has already paid for certain items, such as a trademark royalty or routine operating costs, and thus owns the synergies attributable to those items. The Chandler and Foley article was treated as a comment on the 2008 temporary cost sharing regulations, and the IRS and Treasury Department acknowledged the validity of the reasoning in the article in the preamble to the 2011 final cost sharing regulations:
Comments were received that, with some acquisitions, there may be benefits to the controlled group whose scope extends beyond the development of cost shared intangibles. The Treasury Department and the IRS agree that these facts and circumstances should be taken into account in the appropriate application of the acquisition price method and any other methods for purposes of determining the best method….
~ Federal Register, Vol. 76, No. 246 (December 22, 2011), p. 80085.
Thus, the government has acknowledged the validity of the "Chandler-Foley carve out" from the acquisition price method for synergies attributable to other items the PCT payor has already paid for previously. The PCT payment must focus solely on the value of the cost shared intangibles by themselves, not on anything that extends beyond their scope.
It remains to be seen whether the courts will agree with the reasoning behind the "Chandler-Foley carve-out," but since the rationale is similar to the other carve-outs discussed above, taxpayers may be able to argue that they are entitled to carve out such synergies from the acquisition price method.
Identify the source and nature
To analyse the acquisition premium in an application of the acquisition price method, it is important to identify the source and nature of the acquisition premium, especially those acquisition benefits to the controlled group whose scope extends beyond the development of cost shared intangibles.
Nath, Eric, "Best Practices Regarding Control Premiums," Journal of Business Valuation, 2: 25-30, 2011.
Chandler, Clark and Foley, Sean, "Why the Acquisition Price Method and Income Method Give Different Answers Under the Same Set of Facts," Bloomberg/ BNA, 19 Transfer Pricing Report 861, Dec, 2, 2010.
Cornell, Bradford, "Guideline Public Company Valuation and Control Premiums: An Economic Analysis," Journal of Business Valuation and Economic Loss Analysis, 2013.
Deloitte Tax LLP
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Keith Reams is the US and Global Leader for Clients and Markets for Deloitte's Global Transfer Pricing Services practice. He has advised clients around the globe on intercompany pricing transactions with respect to income tax regulations in Argentina, Australia, Belgium, Brazil, Canada, Chile, China, Colombia, Czech Republic, Denmark, France, Germany, India, Ireland, Israel, Italy, Japan, Korea, Luxembourg, Malaysia, Mexico, the Netherlands, Norway, Peru, Poland, Singapore, South Africa, Spain, Switzerland, Taiwan, Thailand, the United Kingdom, and the United States. He has assisted numerous multinational companies with international valuation and economic consulting services involving merger and acquisition activity, international tax planning, and restructuring and reorganization of international operations. Keith is on the global tax management team for Deloitte's Technology, Media and Telecommunications practice and is a leader in the area of transfer pricing for newly emerging industries, such as electronic commerce and cloud computing, where he has extensive experience around the world in helping clients extend their business models into new territories.
Keith has testified as a qualified expert in numerous valuation and transfer pricing disputes, including the cases of Nestle Holdings Inc. v. Commissioner; DHL Corp. v. Commissioner; and United Parcel Service of America, Inc. v. Commissioner. In addition, he is one of only three economists in the United States approved by the New York State Department of Taxation and Finance to provide transfer pricing expertise and testimony in cases involving cross-border transactions within commonly controlled affiliated groups. He has also helped many clients to successfully resolve valuation and transfer pricing disputes before they reach trial.
Keith completed course requirements for a Ph.D. in International Finance from New York University. He holds a Master of Arts in Economics from California State University Sacramento and a B.S. degree in Chemical Engineering from Stanford University.
Deloitte Tax LLP
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Lawrence Shanda is a director in the New York office of Deloitte Tax's transfer pricing group, and is the Northeast Region transfer pricing leader for business model optimisation studies. His primary responsibilities include economic consulting relating to transfer pricing and intellectual property issues.
Mr Shanda's experience includes more than 25 years of consulting related to intellectual property and intangible assets. His expertise in this area, which includes the valuation of intellectual property and intangible assets, the development of royalty rates, and the determination of damage calculations, has been provided for reasons such as transfer pricing related to international and domestic planning and compliance projects, infringement litigation, tax purposes, merger and acquisition activity, strategic planning, and bankruptcy proceedings.
Mr Shanda has authored a number of articles on intellectual property, the licensing of intellectual property, and the tax treatment of intangible assets. In addition, he has made numerous presentations on the subjects of intangible assets and intellectual property and intellectual property rights to audiences ranging from an IRS economist training session to the Licensing Executives Society.
Masters of Business Administration, Fox School of Business and Management, Temple University
BS, Medical Technology, Edinboro University
Deloitte Tax LLP
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Joe Tobin is a senior manager in global transfer pricing at Deloitte's Washington national tax practice. Joe was the primary drafter of the Treas. Reg. §1.482-7 (2011) Final Cost Sharing Regulations. Joe was previously the senior counsel at the IRS Office of Associate Chief Counsel (International) (Branch 6) (Transfer Pricing) in Washington DC, where he was a reviewer for several high profile transfer pricing litigation cases, including VERITAS, Medtronic, Amazon, and BMC Software. He has spoken at numerous conferences, webcasts, and training sessions on transfer pricing and cost sharing. He has been a member of the Georgetown Law Adjunct Faculty since 2013, where he co-teaches a class on transfer pricing.
Deloitte Tax LLP
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Wen-Fang works with multinational companies in developing intercompany pricing strategies on a variety of transfer pricing assignments, including IP planning, global supply chain planning, audit defense, and global documentation. Wen-Fang has more than 10 years of experience in leading and managing intellectual property planning studies and global transfer pricing documentation projects, and implementing and modifying global transfer pricing policies to support clients' overall business and tax objectives. She has served major clients in the industrial equipment, technology, automotive, medical device, pharmaceutical, and financial services industries, among others. Wen-Fang speaks at numerous tax conferences.
Before joining Deloitte, Wen-Fang was an Assistant Professor of Economics at the University of Washington. In that function, Wen-Fang taught undergraduate and graduate Macroeconomics courses, gave seminar presentations at universities and Federal Reserve banks, and published a number of articles in leading Economics journals.
Wen-Fang holds a Ph D. in Economics from the University of Chicago.