Using Discounted Cash Flow to Apply the CUT Method

Oct 9, 2013

As we discussed in a previous blog, “Can’t See the CUTs? Consider Looking at Your Own License Agreements,” when a taxpayer can apply the Comparable Uncontrolled Transaction (“CUT”) method using as comparables its own transactions for intangible property with third parties, the results are likely to be reliable and defensible. One reason this approach is so useful is that the decision to enter into agreements with third parties is often informed by financial analyses—specifically, discounted cash flow (“DCF”) analyses. Such analyses can be helpful in assessing the comparability of the intangible property in the controlled transfers (intercompany transactions between two or more of a taxpayer’s entities) and the comparable set of uncontrolled (or third party) transactions.

For example, under the IRS section 482 regulations, to apply the CUT method, the taxpayer must identify uncontrolled transactions that are comparable to the controlled transaction based on the following factors: [1]

  1. Comparable intangible property:
    1. Similar products or processes within the same general industry or market
    2. Similar profit potential
  2. Comparable circumstances:
    1. Terms of transfer
    2. Stage of development
    3. Rights to receive updates, revisions or modifications
    4. Duration of license
    5. Uniqueness of property and degree and duration of protection
    6. Economic and product liability risks assumed by transferee
    7. Existence of collateral transactions
    8. Functions performed by licensor and licensee

Each of these factors should be considered in determining possible adjustments, and each of these factors (except 1.1.) should also be reflected in financial analyses for the controlled and uncontrolled transactions.

Consider, for example, a multinational pharmaceutical firm that is actively engaged in the marketplace for in-licensing and out-licensing the intangible property embodied in pharmaceutical compounds. In this circumstance, controlled transfers of the intangible property embodied in pharmaceutical compounds should meet comparability criterion 1.1., above. This is one of the benefits of a company using its agreements with third parties as CUTs. All of the other comparability criteria should be reflected in DCF analyses for the respective compounds. Specifically:

  • Similar profit potential: DCF analysis estimates the profit potential of products and projects. It specifically considers all relevant cash flows associated with the project, including net sales, cost of goods sold, royalties, marketing, R&D, and other cash flows.
  • Terms of transfer: Such terms typically include, for example, geographic limitations, degree of exclusivity, and field of use. The ability to sell the product in a wider and more lucrative geographic area and field of use would, other things equal, increase the net sales and the total value of the project. Similarly, obtaining more exclusive rights would reduce the risk of entry and decrease the risk, and therefore the discount rate, associated with the project. A lower discount rate, other things equal, increases the value of the project.
  • Stage of development: Because cash flows are discounted to reflect the time value of money and the risk associated with the project, other things equal, a project at an earlier stage of development will have a lower value than the same project would have at a later stage of development.
  • Rights to receive updates, revisions or modifications: The ability to participate in updates, revisions, or modifications to the project would, other things equal, likely increase the net sales and reduce the risk of obsolescence of the project. Both factors would increase the value of the project.
  • Duration of the license: The longer the term of the license, other things equal, the greater the profits and the higher the value of the project.
  • Uniqueness of property and degree and duration of protection: The more unique the property and the duration of legal protection of exclusivity, other things equal, the more valuable the project. For example, particularly unique property with many years of protection may enjoy higher levels of net sales for a long period of time.
  • Economic and product liability risks assumed by transferee:  Because the taxpayer is using its own agreements with third parties for similar intangible property in the same industry as comparables, it likely bears similar economic and product liability risks in the controlled and uncontrolled transactions. Relevant risks would typically be reflected in the projected cash flows or discount rate applied to the project.
  • Existence of collateral transactions: To the extent they affect the value of the transfer of the relevant intangible property, collateral transactions would affect the cash flows and potentially the risk associated with the project. Moreover, if a project includes substantial collateral transactions that are integral to the agreement, the taxpayer should consider whether they are appropriate for use as comparables.
  • Functions performed by licensor and licensee: The functions that the licensor and licensee agree to perform will affect their respective costs. If a party performs additional functions and bears the associated costs, other things equal, the value of the project to that party will decrease.

As this discussion describes, financial information that is used to decide whether to enter into a license agreement is often available and useful for comparability adjustments. Specifically, the DCF framework that is typically applied in making such decisions, or may be applied using information that was available at the time of the transaction, incorporates the revenues, costs, and risks associated with the transactions.

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If you are interested in learning more about Edgeworth's experience using a company’s own license agreements as CUTs for intangible property, please contact George Korenko at gkorenko@edgewortheconomics.com.



[1] IRS section 482 regulations, 1.482-4(c)(iii)(B).

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