Applying the CUT Method Using DCF Analysis

Feb 5, 2014

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As I discussed in “Can’t See the CUTs? Consider Looking at Your Own License Agreements,” taxpayers who are active in the marketplace for intangible property may be able to apply the Comparable Uncontrolled Transaction (“CUT”) method using as comparables their own license agreements with third parties. In “Using Discounted Cash Flow to Apply the CUT Method,” I discussed how financial information that is used by companies to decide whether to enter into license agreements—typically in the form of discounted cash flow (“DCF”) analyses—can be used to assess comparability and make necessary adjustments. DCF analysis is used to calculate the net present value (“NPV”) of the cash inflows and outflows. If the NPV of the license is positive, it would be expected to add value to the firm. I received several comments from people who expressed interest in seeing how this method is implemented. Let me walk you through it using a stylized example.

Consider a hypothetical example of an internally developed pharmaceutical product, Elixir, for the firm EdgeworthPharma (catchy name, huh?). Assume that Elixir was developed in the U.S.  and will be manufactured and marketed outside the U.S. by the company’s subsidiary in Singapore. To manufacture and sell the product outside the U.S., the Singapore-based subsidiary will require a license (i.e., is the licensee) from the research facility in the U.S. (the licensor).  Also assume EdgeworthPharma first began specific development of Elixir in 2008, and subsequently incurred substantial annual expenses. Patent protection for Elixir expires in 2017.

Suppose a review of EdgeworthPharma’s license agreements with third parties yields four agreements for licensing the intangible property embodied in a pharmaceutical product. For each of these agreements, the NPV of net income for the licensor is calculated as the present value of all the royalty and lump sum payments from the licensee. The NPV of net income for the licensee is calculated as the present value of the cash flows (annual revenues less costs). The sum of the NPV of net income for the licensor and licensee equals the total NPV of net income, or profit potential, for the product. The shares of the total NPV of net income to the licensor and licensee represent the behavior of the parties in dividing the present value of the profits from the product.  See Table 1. These four agreements provide the basis for identifying comparable uncontrolled transactions. 

 

In EdgeworthPharma’s arm’s length agreements with third parties, the share of the total NPV of net income to the licensor ranges from 18 percent to 33 percent. This represents the consideration paid for the rights associated with the use of the intangible property.

A financial analysis is then prepared for Elixir, using the revenue and cost projections provided to management when making decisions regarding the product. In this case, the total NPV of net income from non-U.S. sales of Elixir equals $843.1 million. See Table 2.

 

To identify the CUT using these financial analyses, the section 482 regulations suggest a comparison of the profit potentials for the controlled and uncontrolled transactions. In this case, among the potential comparable uncontrolled transactions in Table 1, the profit potential for the FluGone agreement most closely matches that for Elixir. As discussed in my previous blog post, adjustments for all other comparability factors are already incorporated into the financial analyses. Therefore, based on the company’s experience in the marketplace for similar intangibles, the arm’s length price for the intangible property embodied in Elixir equals 22 percent of the NPV of net income, which is the share for FluGone. Using the financial analysis for Elixir, it is straightforward to calculate the royalty rate that provides this arm’s length result. Tables 3 and 4 show the financial analyses for the licensee and licensor in the controlled transaction, respectively. The royalty rate that results in the arm’s length share of 22 percent to the licensor is 13.7 percent. 
 
As you can see, a taxpayer that has contemporaneous financial analyses for its licenses (potential comparable uncontrolled transactions) with third parties can be extremely valuable. Not only do the agreements and financial analyses provide arm’s length comparables, but also the financial analyses facilitate identifying a CUT and making necessary adjustments.

Experts

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