Transfer pricing backdrop
With revisions to the OECD's transfer pricing (TP) guidelines on special considerations for intangibles and global tax authorities' compliance focus on intangibles, it is important to confirm that these assets are appropriately valued by multinationals – particularly in related-party disposal and licensing contexts. In this article we explore important valuation matters, including quantifying the role of brands in value chains, and examine why effective TP analyses can require input from intellectual property (IP) and brand specialists.
The international 'Guidance Note on the Valuation of Intellectual Property Rights' (issued by the Royal Institution of Chartered Surveyors, or RICS) states that brand valuation requires multi-disciplinary inputs because of the importance of the underlying legal rights, and the impact of the asset's functional and economic characteristics on commercial utility.
In addition to corporate finance expertise, the multi-disciplinary inputs identified by RICS are an assessment of the IP protecting the brand (brand IP), and an assessment of the brand's impact on consumer attitudes and behaviour. The rationale is that the value of a brand is a function of the earnings that it is expected to generate, together with the associated risk. These functions are directly influenced by consumer attitudes toward a brand, and the legal remedies that prevent third parties eroding its distinct identity.
Pricing royalties for TP purposes requires similar inputs. In this article, the term 'brand evaluation' collectively refers to brand valuations and royalty determination, both of which evaluate the earnings potential of brands.
There is no generally accepted legal definition of the term 'brand', and the OECD's recent guidance arguably expands the definition of intangibles beyond legal concepts. Legal ownership flows from different types of IP, including:
- Registered trade marks (in each jurisdiction, trade mark registrations are by class and in respect of specific goods and/or services);
- Common law rights in trade marks (depending on the law in the relevant jurisdiction);
- Copyright in artistic works within the brand logo; and
- Registered designs.
Although often bundled for arm's-length transactions, these are distinct legal rights that can vary between jurisdictions and classes of product and service. A further complication is that ownership of each right can be held by different parties. For instance:
- Trade marks for the same brand can be owned by different parties in different jurisdictions; and
- When a trade mark includes an artistic work, this might also be protected by copyright, which is a separate and distinct right that can be owned by a different party.
Some brand transactions include a broader bundle of rights, such as copyright in marketing collateral, confidential information in recipes and/or formulations, and URLs and social media sites.
The ability of a brand to generate incremental earnings, compared to the underlying product or service, results from its influence on consumer attitudes and purchasing behaviour. Consumer response can be triggered by any aspect of a brand's identity, including its name, logo, tag line, specific colours, and other aspects of packaging. The broader and deeper the legal protection held by a brand owner, the better it can protect brand differentiation and earnings. Breadth of protection enables differentiation of a variety of elements of visual identity to be maintained. Deeper protection provides the brand owner with a variety of legal remedies to infringement of core elements of the brand identity.
The strength of brand IP influences the ability to protect brand differentiation and the resulting earnings. As this drives brand value, it is necessary for evaluations to clearly identify and assess the relevant rights. This mirrors the due diligence that typically accompanies the sale or licence of brand IP.
The focus of this section is on the ability of legal rights to protect brand value. It is recognised that the concept of economic ownership can also be relevant to TP.
Brand equity and brand economics
The IP that protects a brand's identity is fundamental to its value, but the extent of its value depends on the associated 'brand equity'. This is a term used by marketers to describe the reputational stock that consumers hold towards a brand, and which is inextricably linked to the brand IP.
Market researchers use a layered approach to quantify brand equity. A typical measurement hierarchy starts with brand familiarity, which is a necessary foundation, but is of little value without positive associations. Measures of perceived quality represent the next layer, and are balanced by measures of brand image and relevance. Brand preference flows from the preceding brand attributes and is typically the best predictor of consumer behaviour.
Sophisticated brand owners track the equity of their brands over time, and relative to competitors, through quantitative consumer research. The value chain linking brand equity to consumer behaviour can be assessed through research techniques such as:
- 'Blind tasting' studies, which use two panels to rate the relative quality of products, and quantify the difference in responses between the panel that had visibility of the tested brand compared to the panel that was 'blind' to the brand identities;
- Conjoint (or trade-off) analysis, which is a statistical technique used to determine the impact of brand equity on consumer choice and willingness to pay a premium; and
- Econometric modelling, which isolates and quantifies the historic impact of changes in brand equity on a dependent variable, such as sales.
The reliability of any such analysis depends on factors that include the credentials and independence of the researcher, the scope and methodology of the research, and data quality.
Within a product or service category, strong brand equity drives the earnings of the underlying product by influencing buyer behaviour. In arm's-length licences, this is a primary factor that influences the level of royalty that an independent licensee is willing to pay. Valuation and TP practitioners can use frameworks that quantify brand equity when analysing royalty comparables and when conducting profit split analysis.
Integrating these concepts into brand evaluations
The following paragraphs summarise how brand IP and brand equity should be integrated into brand evaluations. The first three subheadings are common to both valuations and royalty determination; thereafter, consideration is given to other valuation assumptions.
Definition of the subject asset is the cornerstone of a brand evaluation. Lack of clarity compromises all subsequent market and financial analysis. Without defining the asset, its earnings are unlikely to be reliably forecast. Without reliable projections of earnings, the asset cannot be reliably valued. For evaluations that cover several jurisdictions, it is necessary to consider differences in the extent of brand IP, and its ownership. The impact of differences in the definition of the subject asset are illustrated by the following examples:
- The differential in an appropriate royalty rate for the same brand in two jurisdictions if certain aspects of brand identity are protected in one market, but not the other; and
- The differential in the value of all IP protecting a brand, compared to a subset of the brand IP that is the subject of an assignment (for instance, an evaluation of a trade mark exclusive of copyright subsisting in the brand identity).
Should the scope of an engagement exclude a legal assessment, it is important that this is disclosed.
It is inconceivable that an evaluation of a physical asset would be carried out without careful assessment of the ownership of all component parts, and of the asset's commercial utility. For purposes of a brand evaluation, it is no less important for the functional, legal, and economic characteristics of the asset to be considered.
Just as research techniques can estimate the impact of brand equity on earnings, the relationship can be established through careful analysis of royalty rates. This is most evident in product categories where there is a large dataset of arm's-length royalty rates. Although royalties are influenced by a range of factors, there is a strong relationship between brand equity and royalty rates.
Measures of market performance, such as market share, growth, price premium, and price elasticity are highly relevant to brand evaluations. However, these measures can be influenced by factors other than brand equity, for instance, differences in product performance.
Brand contribution to earnings
When brand royalties are estimated using the comparable uncontrolled price (CUP) method, the strength of brand IP and brand equity are important comparability factors.
Even when arm's-length licences exist for the same brand in other jurisdictions, it is recommended that analyses consider the extent of brand IP, relative brand equity, and price positioning in each market at the licensing date (in addition to factors such as licence terms, market characteristics, and economic circumstances). In drawing comparisons with external CUPs, assessment of differentials in brand equity and positioning is of even greater importance.
When available, quantitative consumer research can provide actionable insights to assist with profit split analyses. For instance, conjoint analysis can be used to estimate the relative importance of different features in the purchase decision for a brand.
Other valuation assumptions
The income approach is usually most appropriate for brand valuation. Other than for early-stage brands, the cost approach is not appropriate, as there is no linear relationship between marketing expenditure, brand equity, and value. The market approach is complicated by a lack of publicly available data, together with the uniqueness of brand IP and brand equity.
In addition to brand earnings, income-based valuation methods require consideration of the assumptions listed below:
- Earnings growth: brand equity is a lead indicator of consumer behaviour and earnings, so a review of brand equity over time, and relative to competitors, informs assumed growth in brand earnings;
- Useful economic life: declining brand equity and/or inadequate legal protection can be signals that it is inappropriate to assume that a brand will have an indefinite useful life; and
- Risk: when considering an asset-specific risk premium, valuers are advised to consider brand IP and brand equity.
Functions of brand management
When assessing the relative contribution of related parties to brand earnings, it is informative to consider functions associated with managing brand IP and brand equity. These include:
- Registration of trade marks and designs;
- Brand copyright protection through management of contracts;
- Maintenance and enforcement of brand IP;
- Development of global brand strategy;
- Maintenance and enforcement of brand guidelines;
- Brand licensing;
- Development and approval of local marketing plans;
- Execution of annual plans;
- Production of advertising collateral;
- Media costs of marketing communications;
- Consumer research; and
- Brand audits and performance reviews.
For established brands, arm's-length licences usually require licensees to fund many of the functions required to execute the annual brand plan. Sophisticated brand licensors maintain control over management of the brand IP, brand strategy, and brand assurance.
Conclusion: implications for robust TP documentation
The OECD's recent guidance on intangibles requires multinationals to devote material resources to documenting the TP aspects of their intangibles. A critical component of this will relate to brand valuation, having regard to the matters discussed above.
Partner, financial advisory, M&A
Tel: +61 2 9322 3809
Tim Heberden is a partner in Deloitte Australia and leads the IP advantage team that specialises in quantifying, managing, and monetising IP assets. He is the author of the Guidance Note on the Valuation of Intellectual Property Rights (RICS), and a chapter on IP royalty determination for International Licensing & Technology Transfer. Tim is listed on the IAM Strategy 300 – the World's Leading IP Strategists and has been recognised as a leading licensing expert in Asia. He has valued intangible assets in a wide range of industries for purposes of tax compliance, litigation, M&A, IP strategy, financial reporting, and securitisation. He holds an MBA and is a registered business valuer, chartered accountant, fellow of the Australian Marketing Institute, and fellow of the Royal Institution of Chartered Surveyors.
Partner, transfer pricing, Deloitte AustraliaBachelor of Commerce and Laws (Hons.)
Tel: +61 3 9671 7440
Cam Smith is a partner in Deloitte's global transfer pricing practice, with 22 years' transfer pricing and international tax experience working in Australia, Asia, New Zealand and Europe.
Before joining Deloitte Australia, Cam worked with PwC Australia and New Zealand, including leading PwC's New Zealand transfer pricing practice. Prior to his time with PwC, Cam spent five years in Deloitte London's transfer pricing team.
Cam's experience includes advising on a wide variety of complex transfer pricing matters for some of the world's largest multinational corporations. Cam's experience and expertise relate to transfer pricing matters associated with:
Cam is recognised in Euromoney's World's Leading Transfer Pricing Advisors and has been a member of the Australian Treasury's BEPS advisory group.
Cam has good relationships with the Australian Taxation Office personnel and has worked with them in a variety of contexts to achieve successful transfer pricing outcomes.
Cam has authored several transfer pricing articles and contributed to a number of international transfer pricing books.
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