A cliff effect: The new landscape for taxable transactions

New tax act shifts economics of certain transaction structures

The Tax Cuts and Jobs Act (the Act)1 signed into law last Taxable sale of stock vs. taxable sale of December immediately ushered in a wave of unknowns. It’s In general, an acquisition of a trade or business can take only clear, however, that there is a new landscape for negotiating two possible forms, a purchase of equity or a purchase of and structuring taxable acquisitions. Most significantly, the assets. Although certain provisions in the tax law provide for Act reduced the corporate tax rate to 21% for taxable years gain deferral either in whole or in part, a basic tenet of U.S. beginning after Dec. 31, 2017, down from the highest pre-Act federal income tax law provides that gain or loss is recognized rate of 35%. when property is exchanged in a transaction. In such instances, buyers and sellers engaged in taxable transactions face the Although the Act is arguably a boon to corporations overall, fundamental decision of whether to structure the transaction it presents new, nuanced issues when structuring taxable as the sale of equity or the sale of assets. This age-old tension asset acquisitions. Other modifications to the code,2 when between buyers and sellers is an important negotiating point in coupled with the rate changes, may cause ripple effects that many transactions. Sellers are primarily concerned with reducing fundamentally shift the economics of certain transaction their taxes upon sale, while buyers seek higher deductible, structures. One such modification — and a central topic of depreciable and/or amortizable tax basis to shield the future discussion in this article — is the expanded definition of what is taxable income (referred to herein as the tax shield) of the excluded from asset treatment under Section 1221(a)(3) acquired business.3 of the code. This expanded language increases the likelihood As mentioned, the seller’s predominant concern is to pay the that intellectual property held by a business will be taxed at least amount of tax possible upon the sale of the business. If the higher ordinary rates upon a sale or exchange. buyer proposes a taxable asset sale, and that structure results in a greater tax liability to the sellers (which is often the case), The changes imposed by the Act create an environment in which the sellers will demand that the buyer make them whole for buyers and sellers now face a slim margin for error, as their that additional tax liability in the form of additional purchase competing interests are now likely to diverge even further than consideration (referred to herein as the gross-up payment). was previously the case. For buyers, there are new opportunities to enhance economic returns; for sellers, there are heightened risks. This article explores how tax and valuation advice from professionals is essential when navigating this new terrain.

1. P.L. 115-97. 2. All references to the “code” or a “section” are references to the Internal Revenue Code of 1986, as amended, and a section thereof, respectively. 3. This decision can have far-reaching implications to the buyer for years to come because, under Section 1012, the buyer should obtain a cost basis in the assets acquired in the transaction, generally equal to the respective asset’s fair market value. If the buyer acquires the stock of the corporation, the buyer generally will not be able to recover this basis until and unless that stock is disposed of in the future by the buyer (because stock is neither a depreciable nor an amortizable asset). On the other hand, if a buyer acquires the business assets held by the target corporation, and those assets are either depreciable or amortizable under tax law, the basis (to the extent gain has been recognized) may provide incremental depreciation or amortization deductions to the buyer, reducing the buyer’s taxable income in post-close periods. If the target business is held by a C corporation, an asset sale is The value creation and value erosion of a taxable often not desirable due to the inherent double taxation imposed asset sale under the tax regime of Subchapter C. Various provisions of In general, a taxable purchase of business assets will produce Subchapter C ensure that tax is levied first at the C corporation some amount of a tax shield that may be used to offset the future level upon the sale of the business assets, and a second layer taxable income of the buyer. To induce the seller to structure the of tax is levied on the shareholders upon the distribution of the transaction as a taxable asset sale, sometimes the buyer must proceeds (through corporate liquidation or otherwise). However, make the seller whole for the incremental tax liability that the an asset sale may be feasible if the target C corporation has seller incurs. In effect, the buyer (through its gross-up payment) sufficient tax attributes (e.g., net operating losses) to offset the is paying an incremental tax today to receive an incremental effects of double taxation. benefit in future periods. Any astute financier might immediately question this seemingly counterintuitive strategy; however, value A scenario perhaps more common than the taxable sale of can indeed be created, a “win-win” situation, by entering into assets by a C corporation occurs when the target is an S a taxable asset sale, provided there is substantial forethought corporation and the acquisition is a “qualified” stock purchase given to the purchase price allocations. under Section 338(d)(3). In this scenario, the buyer and seller can make a joint election under Section 338(h)(10) to treat the A key factor to the value creation lies in the arbitrage between taxable purchase of the stock as a deemed taxable purchase the buyer and seller rates. This is no more apparent than when of the assets for federal income tax purposes.4 Due to the flow- dealing with an individual seller and a C corporation buyer. The through nature of the S corporation, and by operation of certain gains rate is the rate at which the seller (an rules that adjust the basis of the shareholder’s stock, the general individual) will pay tax upon the sale of his capital assets, and effect is that the gain is taxed only once (rather than twice, as the corporate rate is the rate at which the tax shield will offset under Subchapter C).5 the future taxable income of the buyer (a C corporation). Prior to the Act, the highest individual capital gains rate and the When a taxable transaction is structured as either the actual highest corporate rate were 20% and 35%, respectively. The sale of assets or the deemed sale of assets, the magnitude highest individual ordinary rate — generally, the rate at which of the requisite gross-up payment — which can result from the individual seller would pay tax on the sale of his ordinary tax character differences (ordinary versus capital) — could assets — was 39.6%. completely negate the benefit of the tax shield.

This article discusses some new (and some old) tax considerations a buyer should take into account when purchasing assets, along with the allocations of value assigned to the various asset classes. The Act generally impacts the allocation between capital and ordinary income due to changes to the definition of what is not a capital asset under Section 1221. Finally, this article addresses certain valuation concepts and subjective valuation methodologies that are used to allocate the purchase price to the various asset classes when a transaction is structured as the taxable sale and purchase of a business’s assets.

4. Treas. Reg. § 1.338(h)(10)-1(d)(5)(i). 5. In general, the gain upon sale of the target S corporation’s assets will be recognized by the target S corporation’s shareholders (i.e., it will flow through to the shareholders) under section 1366, and their bases in the stock of the S corporation will increase under section 1367 by a commensurate amount of the gain recognized. However, under section 1374, property that was transferred from a C corporation to the S corporation, and the S corporation’s basis in the asset is determined (in whole or in part) by reference to the basis in the hands of the C corporation, will be taxed at the corporate level if gain is recognized on the sale or exchange of the property within the recognition period (currently 5 years from the time of the S corporation election).

2 A cliff effect: The new landscape for taxable asset transactions By comparing these three rates, it’s readily apparent that the often annual, income production that results from the sale of value creation of a taxable asset sale with a gross-up payment assets in the ordinary course of a person’s trade or business. can quickly dissipate as more of the gain upon sale of the The one-time, sporadic income from the sale of a capital asset corporation’s assets is taxed at the higher, individual ordinary is typically the result of years of accumulated appreciation in rate. To illustrate, consider a basic example in which the pre- the asset’s value. Prior to 1921, the recognition of this lump sum Act tax rates are applied to an individual seller that is selling a windfall in a single year could have unduly subjected a person cash-free, debt-free business worth $100; the seller’s basis in his to a higher rate bracket, resulting in an increased tax liability, S corporation stock is zero, and all the assets inside the business had the appreciated value been recognized as income over are ordinary in character and have been fully depreciated the capital asset’s holding period. The legislative history of the (i.e., their basis is zero). To induce the seller to structure the Revenue Act of 1921 indicates that Congress was concerned transaction as a taxable sale of the business assets, the buyer that the parity of taxation between the two types of assets was pays the seller a gross-up payment of $19.60 ($100 x (39.6% - artificially repressing the sale of capital assets.10 Rather than 20%)).6 In this example, the gross-up payment of $19.60 creates requiring the spreading of this income over multiple years, a benefit to the buyer worth $35 (a fully depreciable basis of Congress opted that a lower, preferential tax rate should apply $100 x 35%). Obviously, this ignores the time value of money, to gains resulting from the sale or exchange of capital assets. as the tax shield may be used only over a span of several years. Under the present code, Section 1221(a) defines a capital asset as The actual benefit to the buyer is something less than $35, property held by a taxpayer (whether or not connected with his depending on the applicable discount rate and recovery trade or business) that is not described in one of the eight broad period of the depreciable assets held by the business. categories enumerated in Sections 1221(a)(1) through (a)(8). In The new tax rates and definitional changes under Section 1221 effect, Congress defined what a capital asset is by describing imposed by the Act compound this buyer-seller dichotomy. For what it is not. If an asset fits within one of these eight categories, tax years beginning after Dec. 31, 2017, the highest individual it is generally treated as an ordinary asset, and ordinary gain is capital gains rate remains unchanged at 20%; however, the generated upon its disposition.11 highest individual ordinary rate and the highest corporate rate In addition to the statutory exclusions of Section 1221(a)(1) are now 37% and 21%, respectively.7 By applying the post-Act through (a)(8), there are several judicial doctrines that may rates to the above example, the buyer pays the seller a gross-up recharacterize gains or losses as ordinary, even though they payment of $17 ($100 x (37% - 20%)).8 In this example, the seem to arise from an asset that meets the statutory definition gross-up payment of $17 creates a benefit to the buyer worth of a capital asset.12 The Supreme Court articulated this when only $21 (a fully depreciable or deductible basis of $100 x 21%), it held “it is evident that not everything which can be called again ignoring the time value of money.9 Under the post-Act property in the ordinary sense and which is outside the statutory rates, a taxable asset sale could very well result in value erosion exclusions qualifies as a capital asset…the term ‘capital asset’ to an unwitting buyer after the time value of money is is to be construed narrowly in accordance with the purpose of accounted for. Congress to afford capital-gains treatment only in situations Capital asset vs. ordinary asset typically involving the realization of appreciation in value In 1913, the first of a series of federal income tax laws was accrued over a substantial period of time, and thus to ameliorate enacted, but it wasn’t until the Revenue Act of 1921 that income the hardship of taxation of the entire gain in one year.”13 Given from the sale or exchange of property was distinguished as the array of applicable authorities in this area of the tax law, a being either capital or ordinary in nature. detailed analysis, taking into account all the subject facts and circumstances, must be undertaken to determine whether income Income arising from the sale or exchange of a capital asset from the sale of property should be characterized as capital or represents a sporadic source of income rather than the regular, ordinary in nature.

6. The gross-up payment from a buyer to a seller will result in additional purchase consideration, which will result in additional gain being recognized by the seller upon sale. Therefore, there is a circular mathematical calculation necessary to calculate the total gross-up payment. For simplicity, this article ignores this gross-up of the gross-up payment. 7. The highest individual rate of 37% assumes that new section 199A, relating to deductions for “qualified business income,” does not apply. 8. Supra note 6. 9. The Act implemented new so-called immediate expensing provisions under Section 168(k) whereby “qualified property” (in general, tangible property with a recovery period of 20 years or less) placed in service after Sept. 27, 2017 and before Jan. 1, 2023, is eligible to be deducted in full by the buyer in the year such property is placed in service. 10. H.R. Rep. No. 350, 67th Cong., 1st Sess. 10 (1921). 11. Unless another section of the code applies to convert that gain into a capital gain (e.g., section 1231). 12. e.g., the Arrowsmith Doctrine. 13. Commissioner v. Gillette Motor Transport, Inc., 364 U.S. 130, 134 (1960).

3 A cliff effect: The new landscape for taxable asset transactions Prior to the Act, “a patent, invention, model or design (whether or not patented), a secret formula or process” was not included in the language of Section 1221(a)(3).18 As a result of the expanded language, Section 1221(a)(3) now describes several other forms of intellectual property that are “self-created.” Under various scenarios — some of which are described below — the Personal Efforts Provision, Prepared-for Provision and Successor Provision could require intellectual property owned by a corporation to be treated as “self-created” and, thus, to be treated as ordinary in nature upon disposition.

At first, it may seem difficult to imagine how the Personal Efforts Provision may apply to intellectual property owned by a corporation. After all, a corporation is merely a legal construct through which a business is conducted. However, query whether Self-created intellectual property a corporation, through the efforts of its employees or third-party The Act modified the language of Section 1221(a)(3), which is services providers, could be considered the creator of property the third category of excluded property under Section 1221(a). under the Personal Efforts Provision. Section 1221(a)(3), which relates to certain self-created property, as amended by the Act, excludes from the definition of a capital In Rev. Rul. 55-706,19 the IRS asserted that a business was not asset the following: the creator of Section 1221(a)(3) property where (1) the property was the result of the combined efforts of numerous individuals • Patent, invention, model or design (whether or not patented) of various backgrounds and trades, (2) the property was the • Secret formula or process product of substantial amounts of capital, and (3) the costs and expenses were paid for by the corporation at the current going • Copyright rate for the services rendered. However, in Rev. Rul. 55-706, • Literary, musical or artistic composition the business was a widely held corporation, and none of the individuals also owned stock or stock options in the corporation. • Letter or memorandum, or similar property14 that is held by Where a taxpayer’s facts diverge from this ruling, the IRS may a taxpayer contend that a different result is more appropriate. For example, (i) Whose personal efforts created such property if intellectual property owned by a closely held corporation is (the “Personal Efforts Provision”);15 created by the sole shareholder that is also an employee of the corporation at the time of its creation, such intellectual property (ii) For whom a letter memorandum or similar property was may be viewed as created by the corporation under the Personal prepared or produced (the “Prepared-for Provision”);16 or Efforts Provision.20 (iii) Whose basis in such property is determined in whole or part by reference to the basis of such property in the hands of the taxpayer described in (i) or (ii) above (the “Successor Provision”).17

14. Treas. Reg. § 1.1221-1(c)(1) provides that the term “similar property” includes property eligible for copyright protection (whether under statute or common law). 15. Section 1221(a)(3)(A). 16. Section 1221(a)(3)(B). 17. Section 1221(a)(3)(C). 18. Interestingly, similar language — a patent, invention or design — was included in the proposed bill of the predecessor to section 1221(a)(3) (enacted under the Revenue Act of 1950); however, as the result of what appears to have been effective lobbying, that language was stricken before it was signed by President Truman. Thus, the new language added to section 1221(a)(3) partially curbs, though does not fully end, what some have viewed as long-standing policy discrimination toward creators of art, literature and music. See Madelyn S. Cantor, Tax Policy: Copyrights and Patents, 31 Vill. L. Rev. 931 (1986); section 1235 specifically provides that the disposition of patents by certain individuals will be afforded capital gains treatment. 19. 1955-2 C.B. 300, superseded on other grounds by Rev. Rul. 62-141, 1962-2 C.B. 182. 20. See also Commissioner v. Ferrer, 304 F.2d 125 (2d Cir. 1962). In Ferrer, the individual taxpayer, through a sole proprietorship, was engaged in the production of a musical (which has potential to be property under section 1221(a)(3)). The court commented that “although [the contract] demanded Ferrer’s personal efforts in the play’s production, much else in the way of capital and risk-taking was also required…Ferrer’s role as producer, paying large sums to the theatre, the actors, other personnel and the author, is not analogous to that of [a creator under section 1221(a)(3)].

4 A cliff effect: The new landscape for taxable asset transactions The Successor Provision commonly applies to intellectual property When a corporation’s employees create intellectual property for acquired by a corporation from its founding shareholder who the corporation, they invariably document its aspects in order created the property. For example, if an inventor contributes to effectively use in the business the know-how it embodies, or an invention to a corporation in an exchange qualifying under to obtain infringement protection. Because of this, the Prepared- Section 351, the corporation typically takes a carryover basis in for Provision may act to characterize a substantial amount of a the property (i.e., the corporation has the same basis in the asset corporation’s intellectual property as being ordinary in nature. that the inventor had).21 This meets the language of the Successor For example, consider a patent of a product invented by a Provision, irrespective of whether any partial gain is recognized corporation’s R&D department. During the process of invention, by the inventor upon the contribution to the corporation.22 The the R&D department will document the substantial aspects of statutory construct of the Successor Provision makes it clear the product through written notes, various internal memos and that the invention would be treated as an ordinary asset upon a technical research papers. A patent agent (e.g., a third-party disposition by the corporation. or in-house patent attorney) will then use this documentation in conjunction with interviews with members of the R&D department Finally, the Prepared-for Provision requires a corporation to treat — that also may be recorded and retained by the corporation certain intellectual property it owns as ordinary in nature. As — to draft the patent application. The patent application discussed above, the Prepared-for Provision requires that a letter will document the detailed claims to be protected against memorandum or similar property that was prepared or produced infringement, and it will memorialize the agreement, as to the for the taxpayer be treated as ordinary in nature. Treasury Reg. § claims that the corporation may have, between the corporation 1.1221-1(c)(2) states that “…the phrase ‘similar property’ includes, and the government office that eventually issues the patent. for example, such property as a draft of a speech, a manuscript, a After issuance, all the written documentation that supports the research paper, an oral recording of any type, a transcript of an patent is essential to the patent’s enforcement. The patent and oral interview or of dictation, a personal or business diary, a log or this supporting documentation is retained by the corporation as journal, a corporate archive, including a corporate charter, office a collection of information, which may otherwise be described as correspondence, a financial record, a drawing, a photograph a corporate archive. Therefore, even though the Personal Efforts or a dispatch.” Provision may be inapplicable to the corporation, the Prepared-for Provision may apply to treat the patent as ordinary in nature. In Chronicle Publishing Co. v. Comr.,23 the parent company of the San Francisco Chronicle gifted to a charitable organization The Personal Efforts Provision, Prepared-for Provision, and a newspaper clipping library consisting of several thousand Successor Provision could require intellectual property owned by a catalogued clippings, compiled from all editions of the newspaper. corporation to be treated as “self-created” and thus to be treated The Tax Court, in dicta, conceded Chronical Publishing’s as ordinary in nature upon disposition. The Prepared-for Provision, contention that the Personal Efforts Provision is limited and through a combination of the statute, regulations and common does not apply to a corporate taxpayer. However, the court law, may act as the most likely avenue through which intellectual determined that the catalogued newspaper clippings constituted property will be treated as ordinary. Aside from determining the an archive and, as such, was found by the court to be property character (capital versus ordinary) of property, the valuation of under Section 1221(a)(3) (by way of the Prepared-for Provision). each asset may significantly implicate whether the acquisition In Chronicle Publishing, the court determined that an archive of a business will result in value creation or value erosion when included “…any repository or collection esp. of information… structured as a taxable asset sale. Therefore, in addition to the public or institutional records, historic documents and other tax analysis discussed above, it is crucial to obtain professional materials that have been preserved.”24 valuation advice when allocating the purchase price to each asset. Below, we discuss key considerations and valuation principles used in determining the allocation of the purchase price.

21. Section 362(a). 22. E.g.,under Section 357(c).Section 1221(a)(3)(A). 23. Chronicle Publishing Co. v. Commissioner, 97 T.C. 445 (1991).Section 1221(a)(3)(C). 24. Supra note 21 at 449.

5 A cliff effect: The new landscape for taxable asset transactions Valuing intellectual property To more accurately determine an indication of value of the Theoretically, the value of most intellectual property is best intellectual property, several key considerations are taken measured by the economic benefits expected to arise from into account when analyzing the three factors discussed its commercial exploitation. Although several methods exist to above. For example, careful consideration should be given to estimate the value of intellectual property, those most often identifying and quantifying the potential size of the subject applied focus on the expected cash flows to be generated over market, the timeframe in which that market will be penetrated the property’s remaining useful life. The cash flows attributable and the extent or depth to which it will be penetrated. As part to intellectual property are typically quantified in the context of of this consideration, the elements of a strategic plan that any combination of the following: exploit different geographies or market segments should also be taken into account. This can be a highly subjective exercise; • Incremental revenues from increased product sales created by nonetheless, it is necessary to develop an estimated cash flow the business’s ability to expand its market share or enhance forecast related to the sale of product. the demand for its products (i.e., growing the overall market) • Incremental revenues that the business realizes from its ability In addition to the relevant market-based considerations, the to price its products at a premium anticipated future obsolescence of the intellectual property should be taken into account. It is important to gain an • The business’s ability to reduce the production costs of understanding of the evolution of competing intellectual property its products and to quantify how this may impact the expected useful life of the subject intellectual property. It is also important to consider Once the expected cash flows are determined, the value of the the extent to which the benefits associated with the intellectual intellectual property is estimated by applying a discount rate, or property may decline over time as it approaches the end of its an estimated rate of return, to the projected cash flows, arriving useful life. Both dimensions of obsolescence can be captured by at a present value. The discount rate should reflect the time value assessing the reduction of expected sales and/or profit margins of money as well as the uncertainty, or riskiness, of achieving over time as the advantageous position of the subject intellectual those cash flows. property erodes. Finally, it is possible that the subject intellectual property is expected to be replaced by a next-generation technology within the same product. In this case, product sales or margins may be maintained or even enhanced by the new intellectual property, but the subject intellectual property’s contribution to profit margins should continue to decline.

Other assets may contribute to the economic benefits that will be realized from the exploitation of the intellectual property. Therefore, it may be necessary to identify these other assets (including other intellectual property), separate their contribution to the expected cash flows and isolate the portion of the cash flows attributable only to the subject intellectual property.

Also, consider that intellectual property, such as a patented invention, may not have any discernable value if thedevelopment of a commercially viable product has not evolved enough to reasonably quantify relevant assumptions and inputs to valuation models. This is common for in-process research and development projects that are supported by one or more patents but are not developed enough to quantify the potential size of the addressable market.

6 A cliff effect: The new landscape for taxable asset transactions Once a projection of the expected cash flows is developed, it is then necessary to determine an appropriate discount rate that will be applied to arrive at the present value of the subject intellectual property. The discount rate (or required rate of return) should correspond to the assessed risk relative to achieving the cash flows attributed to the subject intellectual property. Note that the potential subjectivity of the market-based and obsolescence- based assumptions (as discussed above) suggest that a relatively high rate of return may be justified to reflect the level of uncertainty associated with estimating expected cash flows from the subject intellectual property. This observation is consistent with the notion that the rate of return corresponding to a particular asset category increases as you move from the top to the bottom of a corporate . That is, the rate of return required for accounts receivable and similar current assets (those relatively certain in value or return) is generally lower than the rate of return required for inventory, fixed and other tangible assets, intellectual property and (assets that are relatively less certain in value or return, i.e., those assets with greater risk).

This ranking of rates of return can be developed by understanding the expected overall rate of return of a business enterprise, commonly referred to as the weighted average cost of capital (WACC) and applying asset-specific rates of return to the value • Relief-from-royalty method. If the subject intellectual of those assets. By weighting each asset return with its value, it is property possesses similar attributes to other intellectual possible to develop a weighted average return on assets (WARA). property that is known to be transacted in a licensing Note that, at least in theory, the WACC and WARA should be agreement between unrelated parties, the terms of that relatively close or even exactly the same. This exercise is common agreement may be a useful proxy for the subject intellectual and necessary when performing a purchase price allocation in a property. The terms typically include a royalty paid as business combination transaction. a percentage of product sales that utilize the licensed intellectual property, and, if several such agreements The considerations described above can be converted to are identified, then the relative attributes of the intellectual an indication of value using any one or combination of the property can be “scored” as a means to quantify a following methods: market royalty rate from a range of rates identified in the licensing agreements. • Profit differential method. If the subject intellectual property is exploited to enhance an existing product, the economic • Profit-split method. If the subject intellectual property benefit attributable to it may be quantified by comparing was recently commercialized and is supported by a strong sales and profit margins recently achieved by the existing trademark and state-of-the-art manufacturing, then the product with those expected to be realized by producing and expected profit margins may be further dissected into a return selling the enhanced product. In this example, assuming all on the trademark and return on the manufacturing intellectual production processes and supporting assets (e.g., trademarks) property. The residual profit margin would be attributable to are the same, then all incremental profit margins may be the subject intellectual property.25 attributable to the subject intellectual property.

25. Note that if a particular fact pattern allows for the application of both the Relief-from-royalty and Profit-split methods, the outcome of both methods should yield a similar answer (e.g., the royalty rate as a percentage of sales and residual profit margin should be within a reasonable range). Finally, careful consideration must be given to identify and account for any other supporting assets that may also contribute to the incremental profit margins.

7 A cliff effect: The new landscape for taxable asset transactions Please refer to the accompanying example, detailing a taxable • TargetCo’s manufacturing process is expected to be subject asset transaction and its suggested valuation. to continuous improvements as new technologies evolve in the future. As such, company executives believe that the Taxable asset transaction example cost-saving benefits of Process IP will decline to a point of full Background replacement in 10 years. In a transaction that closed on Dec. 31, 2017, BuyerCo bought • NewProduct was developed through exploitation of the the assets of TargetCo for $628 million in cash and did not Patents and is expected to have a revolutionary impact assume any liabilities. BuyerCo and TargetCo have agreed to on TargetCo’s consumer base. Although NewProduct is accept the purchase price allocation performed by a reputable expected to cause some erosion to existing product sales, it third-party appraiser for IRC 1060 reporting purposes. The is expected to more than overcome that erosion and result following are relevant facts: in continued revenue growth for TargetCo. Considering the • The acquired assets of TargetCo include net working capital, duration of legal protection of the Patents and expected property, plant and equipment (PP&E)26, the TargetCo evolution of substitute products that will compete with trademark/logo (Trademark), distribution network, proprietary NewProduct, BuyerCo executives believe that the Patents will process technology (Process IP) and a portfolio of design not exhibit obsolescence for the next five years, but thereafter patents (Patents). Whereas the Trademark and distribution advantages will decline during years six through ten. network were acquired by TargetCo in a prior transaction, the Process IP and Patents were developed by TargetCo and are considered ordinary assets for tax purposes.

• The net working capital (including inventory) and PP&E have

been appraised and have been assigned fair values of

$55 million and $120 million, respectively.

• The Trademark is very strong as TargetCo enjoys a loyal following from consumers for its products. In effect, the products are pulled through the distribution network via strong consumer demand. As such, the Trademark is considered to be a much more valuable asset than the distribution network. The value of the distribution network was considered nominal and accordingly no value was assigned to it. • The Process IP was created and utilized to upgrade TargetCo’s manufacturing process in an effort that had been completed toward the end of 2016. As a result of the upgrade, which was made solely via application of the Process IP, the cost to manufacture was reduced by $8 per item produced. • During the past year, the upgraded manufacturing line was expanded to accommodate production of a new product (NewProduct), which was launched three months prior to the close of the transaction. Early indications are that the Process IP is providing the same $8 cost savings for each NewProduct manufactured.

26. Property, plant & equipment (also referred to as personal property and real property).

8 A cliff effect: The new landscape for taxable asset transactions Valuation analysis Note that growth in volumes for Existing products is expected We’ve already indicated that the acquired net working capital to slow while volumes for NewProduct are expected to ramp and PP&E have been appraised, so the objective of this up quickly over the next five years before also tapering off. exercise is to estimate the value of the Trademark, Process IP, Similar patterns are expected for product unit pricing. The and Patents. This analysis is presented in the six schedules sales forecast model was extended over 10 years to capture described below: the volume and pricing patterns noted above and the obsolescence in the Process IP and Patents expected to occur • Schedule A, Sales forecast – Sales forecast presented over a over the same period. 10-year period by Existing products versus NewProduct.

Schedule A: Process IP—Sales forecast (all figures 000, except unit pricing)

2018 2019 2020 2021 2022 2023 2024 2025 2026 2027

Existing products

Unit price $200 $206 $212 $218 $225 $232 $239 $244 $247 $250 Volume 1,500 1,550 1,600 1,550 1,560 1,575 1,600 1,600 1,600 1,600 NewProduct Unit price $280 $288 $297 $306 $315 $324 $334 $344 $354 $360

Volume 500 650 750 825 875 910 925 950 975 1000

Total sales $440,000 $506,500 $561,950 $590,350 $626,625 $660,240 $691,350 $717,200 $740,350 $760,000 Annual growth 15.1% 10.9% 5.1% 6.1% 5.4% 4.7% 3.7% 3.2% 2.7%

9 A cliff effect: The new landscape for taxable asset transactions • Schedule B, Discounted cash flow model – Discounted value is calculated using the Gordon Growth Model (g), which cash flow model presented to determine the internal rate assumes a long-term annual growth in debt-free cash flow. of return (IRR) that reconciles the financial projections of In this case, g = 3% to reflect a long-term inflationary growth TargetCo with the purchase price paid ($628 million) expectation. Note, too, that the sales forecast in years six by BuyerCo. through ten as shown in Schedule A ranges from 5.4% down to 2.7%. It was assumed, for sake of simplicity, that g = 3% In this example, the IRR is 12.5%. Note that the income tax into perpetuity still captures these short-term growth rates rate is 26%, which is a combination of the 21% federal tax above 3%. rate plus an average blended state rate of 5%. The terminal

Schedule B: Discounted cash flow model (all figures 000, except unit pricing)

2018 2019 2020 2021 2022

Total sales $440,000 $506,500 $561,950 $590,350 $626,625

Cost of goods sold $242,000 $278,575 $303,453 $318,789 $332,111 Percentage 55% 55% 54% 54% 53% Gross profits $198,000 $227,925 $258,497 $271,561 $294,514 Percentage 45% 45% 46% 46% 47% Operating expenses $132,000 $151,950 $168,585 $177,105 $187,988 Percentage 30% 30% 30% 30% 30% EBIT $66,000 $75,975 $89,912 $94,456 $106,526 Percentage 15% 15% 16% 16% 17% Income taxes @ 26% $17,160 $19,754 $23,377 $24,559 $27,697 Debt-free net income $48,840 $56,222 $66,535 $69,897 $78,829 Cash flow adjustments* $(7,326) $(8,433) $(9,980) $(10,485) $(11,824) Debt-free cash flow $41,514 $47,788 $56,555 $59,413 $67,005 PV factor @ 12.5% 0.943 0.838 0.745 0.662 0.589 PV cash flow $39,148 $40, 047 $42, 133 $ 39, 331 $39, 466 Discrete period value $200,125 Terminal value** $427,894 Purchase consideration $628,000 (rounded)

*Includes non-cash expenses, capital expenditures, and incremental working capital **Calculated using Gordon Growth Model: ($67,005 x (1 + 3%)) / (12.5% - 3%) x 0.589

10 A cliff effect: The new landscape for taxable asset transactions • Schedule C, Trademark—Relief-from-royalty method – Since the strength of the Trademark is expected to help drive Trademark valuation using the relief-from-royalty method. all product sales, the royalty rate was applied to total sales as shown in Schedule A and is assumed to continue into A “market” royalty rate equal to 2.5% of product sales was perpetuity. Value is estimated by tax-affecting the cash flows developed by analyzing the parties to and terms of several and present-valuing them using a rate of return commensurate publicly disclosed trademark licensing agreements prevalent with the risks associated with deploying the Trademark. The in TargetCo’s consumer-oriented industry. Those royalty rates perpetuity assumption is reflected by the terminal value which ranged from 1.0% to 3.0% of sales, and an attribute scorecard again is based on the Gordon Growth Model and g = 3%. was implemented that resulted in a concluded rate of 2.5%.

Schedule C: Trademark—Relief-from-royalty method (all figures 000, except unit pricing)

2018 2019 2020 2021 2022 2023 2024 2025 2026 2027

Total sales $440,000 $506,500 $561,950 $590,350 $626,625 $660,240 $691,350 $717,200 $740,350 $760,000 Royalty @ 2.5% $11,000 $12,663 $14,049 $14,759 $15,666 $16,506 $17,284 $17,930 $18,509 $19,000 Income taxes @ 26% $2,860 $3,292 $3,653 $3,837 $4,073 $4,292 $4,494 $4,662 $4,812 $4,940 Net royalty income $8,140 $9,371 $10,396 $10,922 $11,593 $12,214 $12,790 $13,268 $13,697 $14,060 PV factor @ 12.5% 0.943 0.838 0.745 0.662 0.589 0.523 0.465 0.413 0.367 0.327 PV cash flow $7,676 $7,853 $7,745 $7,230 $6,828 $6,388 $5,947 $5,480 $5,027 $4,598 Discrete period value $64,772 (See terminal Terminal value $49,848 value in schedule B) Trademark fair value $115,000 (rounded)

11 A cliff effect: The new landscape for taxable asset transactions • Schedule D, Process IP-Process differential method – become obsolete over the next 10 years, it was assumed that Process IP valuation using profit differential method. the decline will follow a straight line from 100% in 2018 to 10% in 2027. Value is estimated by tax-affecting the cash flows and The $8 per unit manufacturing cost savings is direct present-valuing them using a rate of return commensurate with evidence of the value of the Process IP. It’s simply a matter of the risks associated with deploying the Process IP. Note that multiplying the cost savings by the number of units produced since the Process IP is not expected to provide any benefits to quantify the cash flow benefit attributable to the Process after 2027, there is no terminal value calculation. IP. Thereafter, since it is expected that the Process IP will

Schedule D: Process IP - Profit differential method (all figures 000, except unit pricing)

2018 2019 2020 2021 2022 2023 2024 2025 2026 2027

Existing products

Volume 1,500 1,550 1,600 1,550 1,560 1,575 1,600 1,600 1,600 1,600 NewProduct Volume 500 650 750 825 875 910 925 950 975 1,000 Total volume 2,000 2,200 2,350 2,375 2,435 2,485 2,525 2,550 2,575 2,600 Cost savings @ $16,000 $17,600 $18,800 $19,000 $19,480 $19,880 $20,200 $20,400 $20,600 $20,800 $8 per unit Obsolescence factor 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% Adj. cost savings $16,000 $15,840 $15,040 $13,300 $11,688 $9,940 $8,080 $6,120 $4,120 $2,080 Income taxes @ 26% $4,160 $4,118 $3,910 $3,458 $3,039 $2,584 $2,101 $1,591 $1,071 $541 Net benefit $11,840 $11,722 $11,130 $9,842 $8,649 $7,356 $5,979 $4,529 $3,049 $1,539 PV factor @ 13.5% 0.939 0.827 0.729 0.642 0.566 0.498 0.439 0.387 0.341 0.3 PV cash flow $11,118 $9,694 $8,114 $6,319 $4,895 $3,663 $2,625 $1,753 $1,040 $462 Process IP fair value $50,000 (rounded)

12 A cliff effect: The new landscape for taxable asset transactions • Schedule E, Patents-Profit split method – Patent valuation The cash flow remaining after deducting the contributory using profit-split method. asset charges (excess cash flow), is logically attributable to the Patents. Thereafter, it is expected that the Patents will Since we were able to value the Trademark and Process IP maintain full value for five years and become obsolete over using direct valuation methods, we can apply an indirect the subsequent five years; we assumed a straight-line decline method to the valuation of the Patents and use the values during the latter five-year period. Value is estimated by for the other assets as inputs. We start with the premise that tax-affecting the excess cash flows and present-valuing them Earnings Before Interest and Tax (EBIT) reflects the expected using a rate of return commensurate with the risks associated return on all assets deployed in TargetCo. Thereafter, we with deploying the Patents. Finally, similar to the Process IP, deduct a portion of EBIT attributable to each asset category note that since the Patents are not expected to provide any based on its value and rate-of-return profile. This in turn is benefits after 2027, there is no terminal value calculation. converted to a margin on sales. These metrics are commonly referred to as contributory asset charges. For example, the charge for PP&E is calculated as the value times the required rate of return divided by total sales. In this case, $120 million x 0.07 / $440 million = 1.9% .

Schedule E: Process IP - Patents - Profit split method (all figures 000, except unit pricing)

2018 2019 2020 2021 2022 2023 2024 2025 2026 2027

NewProduct Unit price $280 $288 $297 $306 $315 $324 $334 $344 $354 $360 Volume 500 650 750 825 875 910 925 950 975 1,000 Total sales $140,000 $187,200 $222,750 $252,450 $275,625 $294,840 $308,950 $326,800 $345,150 $360,000 EBIT $21,000 $28,080 $35,640 $40,392 $46,856 $50,123 $52,522 $55,556 $58,676 $61,200 Percentage 15% 15% 16% 16% 17% 17% 17% 17% 17% 17% Contributory asset charges Net working capital 0.7% $963 $1,287 $1,531 $1,736 $1,895 $2,027 $2,124 $2,247 $2,373 $2,475 PP&E 1.9% $2,673 $3,574 $4,253 $4,820 $5,262 $5,629 $5,898 $6,239 $6,589 $6,873 Brand @ 2.5% $3,500 $4,680 $5,569 $6,311 $6,891 $7,371 $7,724 $8,170 $8,629 $9,000 Process IP @ 4.0% $5,600 $7,488 $8,910 $10,098 $11,025 $11,794 $12,358 $13,072 $13,806 $14,400 Excess cash flow $8,264 $11,051 $15,377 $17,427 $21,783 $23,302 $24,418 $25,828 $27,279 $28,452 Obsolescence factor 100% 100% 100% 100% 100% 90% 70% 50% 30% 10% Adj. cost savings $8,264 $11,051 $15,377 $17,427 $21,783 $20,972 $17,092 $12,914 $8,184 $2,845 Income taxes @ 26% $2,149 $2,873 $3,998 $4,531 $5,664 $5,453 $4,444 $3,358 $2,128 $740 Net benefit $6,115 $8,178 $11,379 $12,896 $16,119 $15,519 $12,648 $9,556 $6,056 $2,105 PV factor @ 14.5% 0.935 0.816 0.713 0.623 0.544 0.475 0.415 0.362 0.316 0.276 PV cash flow $5,718 $6,673 $8,113 $8,034 $8,769 $7,371 $5,249 $3,459 $1,914 $581 Process IP fair value $56,000 (rounded)

13 A cliff effect: The new landscape for taxable asset transactions • Schedule F, Weighted average return on assets, advantage of Bonus depreciation, another feature of the Tax or WARA – Cuts and Jobs Act. However, BuyerCo is indifferent to the values As mentioned earlier, it's important to assess and quantify ascribed to the intangible assets and goodwill because those rates of return expected for each class of assets that make up will all be amortized over 15 years (IRC Section 197). On the other a business enterprise, such that those rates of return reconcile hand, TargetCo will not be happy with the values ascribed to the with the business enterprise. In this example, and as shown Process IP and Patents because those will be treated as ordinary on Schedule F, the rates of return starting at the top are lower assets. TargetCo would prefer to see more value ascribed to the than the WACC (12.5%) to reflect lower risk profiles whereas other asset categories that will be treated as capital assets or, the rates of return associated with the intellectual property are even better, to goodwill, which would have no tax consequences the same or higher than the WACC. For example, the Patents to TargetCo. So, in this illustration, TargetCo will be motivated are considered the riskiest asset due to the lack of history and to examine the appraiser’s work and challenge certain key more speculative view of NewProduct sales versus Existing assumptions that drive the value conclusions of the Process IP product sales. In the end, the resulting WARA reconciles well and Patents. Perhaps the asset rates of return should be higher with the WACC (12.4% versus 12.5%). and/or expected useful lives shorter? Ascribing more value to the PP&E and Trademarks (i.e., higher royalty rate or lower rate Now the appraiser presents the proposed purchase price of return?) would also be helpful as doing so would increase the allocation and resulting asset values to TargetCo and BuyerCo. contributory asset charges (thus reducing value) applied in the What is the likely reaction? Let’s start with BuyerCo. BuyerCo valuation of the Patents. would prefer the value of the PP&E to be higher to take

Schedule F: Weighted average return on assets (all figures 000, except unit pricing)

Asset category Fair value % of total Rate of return Weighted return

Net working capital $55,000 8.8% 5.5% 0.5% PP&E $120,000 19.1% 7.0% 1.3% Trademark $115,000 18.3% 12.5% 2.3% Process IP $50,000 8.0% 13.5% 1.1% Patents $56,000 8.9% 14.5% 1.3% Goodwill (resident value) $232,000 36.9% 16.0% 5.9% Total value $628,000 100% 12.4%

14 A cliff effect: The new landscape for taxable asset transactions Be smart in a changing landscape The valuation examples highlight certain methods used to Prior to the Act, buyers and sellers were faced with considerably appraise different types of intellectual property and demonstrate less risk and greater reward when structuring taxable how these calculations rely on difficult-to-estimate variables, transactions as the purchase and sale of the assets of a business which can have the potential to cause wide swings in value with substantial intellectual property. The Act fundamentally conclusions. These factors provide the opportunity for sellers of changed the landscape in which these transactions must now self-created intellectual property that is subject to the restrictions be negotiated. The expanded exclusions from capital asset of Section 1221 to work with appraisers to develop supportable treatment under Section 1221(a)(3) may cause the requisite assumptions and analyses. This information can then be used gross-up payment to exceed the present value of the expected in negotiations with buyers who have an incentive under the Act tax shield, resulting in value erosion rather than value creation. to seek higher values on acquired assets that depreciate more These structures may be economically untenable, depending on quickly than intellectual property, including capital assets that the facts and circumstances, which is why buyers and sellers qualify for bonus depreciation. should seek professional tax and valuation advice in navigating this new terrain.

VALUING YOUR INTELLECTUAL PROPERTY

Assess expected cash flow/incremental revenues from: • Expanded market share or enhanced product demand

–– Identify and quantify potential market size, market penetration –– Analyze strategic plan, marketing segments • Ability to price product at a premium • Reducing product production costs

Anticipate future product obsolescence:

• Understand evolution of competing intellectual property; quantify impact on product’s useful life • Consider extent of product benefit decline • Capture both by assessing reductions in expected sales and/or profit margins over time as product’s market position erodes • How would a next-generation product technology impact your product?

Other factors:

• Identify other assets contributing to the intellectual property’s economic benefits • Separate their contribution from those attributable only to the subject property • If a patented invention, may not yet be commercially viable or have discernable value

Determine an appropriate discount rate to arrive at the present value:

• Should correspond to the assessed risk relative to achieving the cash flows • Relatively high rate of return may be justified to reflect the level of uncertainty associated with estimating expected cash flows developed by:

–– Understanding the expected overall rate of return of a business enterprise/the WACC & –– Applying asset-specific rates of return to the value of those assets to develop a WARA –– In theory, the WACC and the WARA should be relatively close or the same

15 A cliff effect: The new landscape for taxable asset transactions Contacts

Tim O’Connor Barry Grandon Drew Burnett Managing Director Managing Director Manager Corporate Value Consulting M&A Tax Services M&A Tax Services T +1 312 602 8680 T +1 212 542 9690 T +1 212 542 9623 E [email protected] E [email protected] E [email protected]

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