While the discussion of intellectual property (IP) migration tends to focus on the internal sale of technology, another type of IP that is often sold between related parties and should enter the conversation are customer relationships to maximize operational efficiencies and correspondingly reduce their effective tax rate. Customer relationships are frequently sold internally as part of a company aligning its organizational structure to operate more efficiently on a geographic basis. For example, many U.S.-based companies who expand internationally develop and manage their customer relationships from the U.S., thus the relationships reside within a U.S. corporate entity. As the company grows and the business expands globally, it benefits the company to manage its relationships with customers utilizing local resources, i.e. customers in Germany will be handled directly by company employees in Germany, etc.
In this example, as the relationship asset is technically owned by the U.S. entity, it must be first be sold to the related German entity. In doing so, the fair market value of the specific customer relationships that will be sold to the German entity becomes the key aspect of the transaction given it will determine any potential tax associated with a gain on the sale. Thus, having a firm understanding of how to most appropriately measure the fair market value of the subject customer relationships is an integral part of the process.
There are a few vital aspects relative to the valuation, which is based on an income approach that measures value based on the future income generating capability of the customer relationships. The first step is to isolate the revenues attributable to the German customers and understand the characteristics of these customers, e.g., the expected rate of attrition, the growth rate attributable to the existing customers, etc. However, the area that will really drive value is the profit margin specific to these customers. As we are valuing the existing customers only (thus not valuing future customers), we must isolate the profit margin specific to the existing customers. Any expenses that do not benefit the existing customers (sales and marketing to recruit new customers is a good example) must be excluded from the calculation of the profit margin.
The point at which these analyses get complicated, and where we often encounter issues with these valuations, is the interplay between the customer relationships and technology. If the technology is not being sold as part of the intercompany transaction it must be separated from the customer relationship value. This is accomplished by deducting a “charge” for the use of the technology in the valuation model. This charge is often based on a pre-determined royalty rate or expense based on intercompany transfer pricing agreements. The tricky aspect is that the operating expenses typically include research and development (“R&D”) costs; while the R&D expense is adjusted to include only maintenance R&D required to service the existing customers (thus R&D costs expended to benefit future customers are excluded), in reality R&D expenses should be completely excluded in operating expenses given the owner of the customer relationships does not have rights to the IP, is already paying for the rights to use the IP through the intercompany payment, and has no requirement for incurring any R&D charges since they have no rights or responsibilities for the IP. Including any R&D expenses in this scenario can lead to an undervaluation of the customer relationships, and in our experience is one of the more overlooked aspects for these types of valuations.
On a related note, it is important to recognize that the charge for the use of the technology should be completely consistent with the intercompany transfer pricing agreement (unless the agreement is dated or no longer relevant to current market conditions) to ensure the positions are not conflicting. This pitfall becomes an issue if a valuation of the customer relationships that is conducted for financial reporting purposes is utilized and the charge for the technology was based on a “market participant” rate or another estimate that contradicts the intercompany transfer pricing.
Author: Phil Antoon
We’d love to get your thoughts: How are you approaching the valuation of your customer relationships as part of a sale to a related party entity? Are you appropriately adding back operating expenses attributable to recruiting new customers? How have you captured the interplay between the customer relationships and technology or other IP? Are you undervaluing the customer relationships by double counting for the use of and development of technology? Are you at-risk for scrutiny related to potentially undervaluing by utilizing a valuation that was conducted for financial reporting purposes that may not provide an acceptable value for tax purposes? Please call or aliguori [at] alvarezandmarsal.com (email us) and let us know!