The Identification and Extraction of Intangible Property from Unit Principle Valuations Tia Hutton and John C

Property Tax Thought Leadership

The Identification and Extraction of Intangible Property from Unit Principle Valuations Tia Hutton and John C. Ramirez

Many taxing jurisdictions do not tax intangible property for property tax purposes. However, many taxing jurisdictions assess certain industrial or commercial property based on the unit principle of property valuation. The application of the unit valuation principle typically includes the value of all of a taxpayer’s operating property, including intangible property. The inclusion of intangible property in such a tax assessment can, in some cases, substantially affect the amount of the assessment. For this reason, property owners may retain a valuation analyst to value and subtract any intangible property from the unit principle valuation. First, this discussion summarizes the unit principle valuation of industrial and commercial property. Second, this discussion describes the identification of intangible property and the generally accepted intangible property valuation approaches and methods applicable for property tax purposes. Finally, this discussion presents two methods that are frequently applied to remove the value of intangible property from a unit principle valuation prepared for property tax purposes.

ntroduction and ownership transfer, and so on. The focus of this I discussion is the identification and extraction of The word “assets” is an accounting term and the intangible property value from unit principle valua- word “property” is a legal term. These two terms tions prepared for property tax compliance, appeal, do not necessarily mean the same thing (i.e., all or litigation purposes. assets are not necessarily property and vice versa). First, this discussion summarizes the unit princi- However, for simplicity, these terms are used inter- ple valuation of industrial and commercial property. changeably in this discussion. Second, this discussion describes the process that Intangible property can be very valuable. analysts follow in the identification of intangible Valuation analysts (“analysts”) are often retained property and in the application of generally accept- to estimate the value of intangible property for a ed intangible property valuation approaches and variety of reasons. Such reasons may include trans- methods. Finally, this discussion presents the meth- action pricing and structuring, financial accounting ods that analysts may apply to subtract the value of and reporting, taxation planning and compliance, intangible assets from the total unit value in taxing bankruptcy and reorganization, intercompany use jurisdictions that do not tax intangible property.

www .willamette .com INSIGHTS • SUMMER 2020 3 he nit aluation rinciple In taxing jurisdictions that do not tax intangible T U V P property, both the taxpayer and the assessment For property tax purposes, many taxing jurisdic- authority should ensure that any intangible prop- tions assess certain types of industrial or commer- erty value is excluded from the assessment based on cial property based on the unit valuation principle— the unit valuation principle. and not on the summation valuation principle. If the assessment includes intangible property In a summation principle valuation, a separate that is not subject to taxation, the value of that appraisal is performed for each asset category (or intangible property should be removed from the component) of the taxpayer property. The total assessment (which may be the total unit value). value of the taxpayer property is the sum of the individual asset category values. To perform a summation principle valuation, each category of taxpayer property is subject to Identification of Intangible separate identification and individual valuation. It Property can be difficult to separate each asset category for The initial step in performing an intangible asset certain types of industrial and commercial proper- valuation is to identify the subject intangible asset. ties. For this reason, the summation valuation principle is typically applied to value relatively simple There are numerous legal, accounting, and properties, such as high-rise apartment buildings or taxation definitions for the term “intangible asset.” high-rise office buildings. Most of those definitions typically relate to the specific purpose and are extracted from a par- The unit valuation principle is typically applied ticular statutory authority, administrative ruling, to value more complex properties. In a unit princi- or judicial precedent. This discussion focuses on ple valuation, all of the taxpayer’s operating assets the general economic attributes that help analysts are valued collectively, in the aggregate, as a single determine the existence of an intangible asset. It is unit of property. The total unit value equals the important for the taxpayer and analyst to research value of all of the taxpayer operating assets (both whether a purpose-specific definition of intangible tangible assets and intangible assets) functioning asset exists. collectively on a going-concern, or value in contin- ued use, basis. According to the textbook Valuing Intangible The unit valuation principle is often applied Assets,1 the characteristics or economic attributes when the taxpayer’s real estate and tangible person- necessary for identification as an intangible asset al property is physically, functionally, and economi- include the following: cally integrated. For example, the unit valuation 1. It is subject to a specific identification and principle is often applicable when an industrial or a recognizable description. commercial property operates as a continuous oper- 2. It is subject to legal existence and legal pro- ating process. Examples include oil and gas refiner- tection. ies, chemical and other processing plants, mining 3. It is subject to the rights of private owner- and mineral extraction facilities, cable television ship, and that private ownership should be properties, electric generation plants, hospitals and legally transferrable. nursing homes, and others. 4. It is documented by some tangible evidence Additionally, the unit valuation principle is often or manifestation of its existence (e.g., a applied when the taxpayer property is a utility-type contract, a license, a set of financial state- property that crosses over several counties, states, ments). or other taxing jurisdictions. Examples of such properties include railroads, airlines, interstate and 5. It is created or comes into existence at an intrastate pipelines, water distribution systems, identifiable time or as the result of identifi- wastewater distribution systems, gas distribution able event. systems, electric distribution systems, and telecom- 6. It is subject to being destroyed or to a munications systems. termination of existence at an identifiable The value conclusion of the unit principle valua- time or as the result of an identifiable event. tion includes all of the categories of taxpayer property, including working capital accounts, real estate, In other words, there should be a specific bundle tangible personal property, and intangible personal of rights associated with the existence of any identi- property. Importantly, not all of these property cat- fiable intangible asset. These identifiable intangible egories may be subject to property taxation in the assets should be transferable. relevant taxing jurisdiction.

4 INSIGHTS • SUMMER 2020 www .willamette .com However, this statement does not imply that the n High market share intangible asset has to be readily marketable or that n Lack of regulation the taxpayer owner would ever plan to transfer the intangible asset. n Monopoly position (or barriers to entry) And, this statement does not imply that the n Market potential intangible asset has to be sold separately from n Competitive advantage (i.e., technological all other assets. In fact, just the opposite is true. superiority, uniqueness, economies of scale, Intangible assets are often sold with tangible assets synergies, efficiencies) and/or with other intangible assets. n General positive reputation The above-listed items describes the economic attributes of an intangible asset. Analyst consider these economic attributes in order to determine the existence of an intangible asset. Types of Intangible Property For a variety of accounting, legal, taxation, and other There is a distinction (sometimes substantial) reasons, industrial or commercial property are often between the existence of an intangible asset and distinguished between tangible assets and intangible the value of the intangible asset. It is possible for an assets. Industrial or commercial intangible assets intangible asset to have economic existence while can further be grouped into two categories: having little or no quantifiable value. 1. Intangible real property For an intangible asset to have a quantifiable value from a valuation perspective, it should pos- 2. Intangible personal property sess certain economic attributes. According to the textbook Best Practices: Thought Leadership in Intangible Real Property Valuation, Damages, and Transfer Price Analysis,2 these attributes may include the following: Intangible real property is a familiar category for many taxpayers. This is because it is not uncommon 1. The intangible asset should generate some for legal interests in real estate to be subdivided and measurable amount of economic benefit transferred. Intangible real property is the transfer- to its owner. This economic benefit could able legal interest in real estate. be in the form of an income increment, The value of intangible real property is not a cost decrement, and/or an investment derived from the ownership of the real estate itself. decrement. This economic benefit may The real estate ownership is vested in a separate be measured in any one of the several party (e.g., landlord, the lessor, or the licensor). The ways, including net income, net operating value of intangible real property is derived from the income, net cash flow, and so on. legal rights it grants to real estate. 2. The intangible asset should be able to Examples of intangible real property include enhance the value of the other assets (tan- leases, occupancy permits, building permits, sur- gible or intangible) with which it is associ- face rights, air rights, mining rights, water extrac- ated. These other assets may encompass tion rights, drilling rights, and so forth. In contrast, all other assets of the operating business examples of tangible real property include land enterprise of an owner/operator, including improvements, buildings, and so on. tangible personal property, real estate, or Intangible real property is often documented in other intangible assets. a license, lease, easement, or other contract. This written document provides evidence of the exis- Some inexperienced analysts may confuse the tence of the intangible real property. This written term intangible asset with intangible factors, ele- document has a tangible element (i.e., the paper it ments, influences, or attributes. Some econom- is written on). ic phenomena attributes may contribute to the All intangible assets should have some form existence of—and value of—identifiable intangible of physical evidence of their existence. However, assets. However, such economic phenomena may the value of the intangible real property does not not possess the requisite characteristics to distin- depend on the tangible evidence (e.g., the actual guish them as identifiable intangible assets. physical paper). Rather, the value of intangible Some economic phenomena that do not qualify real property depends on the legal rights (and eco- as an intangible asset—but may be considered intan- nomic expectations) associated with the written gible factors or influences—include the following: document.

www .willamette .com INSIGHTS • SUMMER 2020 5 Intangible Personal Property receivable, notes receivable, stocks and bonds, and other negotiable investment securities. However, The value of intangible personal property is derived inexperienced analysts may not automatically think from the legal rights, the intellectual property of financial assets as intangible assets. content, and/or the expected economic benefits that are associated with this category of intangible As an example, let’s consider cash—in the form assets. of a $100 bill. The $100 bill clearly qualifies as an asset. It is unlikely for anyone to question that the Analysts often group intangible personal prop- $100 bill (1) is subject to ownership and (2) has erty into four categories. The categorization process value. may be relevant from a property tax valuation perspective. This is because the four different catego- What may not be immediately clear is the $100 ries of intangible personal property (although fun- bill’s classification as an intangible asset. The value damentally similar) have slightly different economic of the $100 bill does not result from the physical attributes. paper note (i.e., the physical attributes). Rather, the value of the $100 bill results from the fact that Sometimes this intangible personal property the intangible asset owner has the legal right to categorization process may have accounting, taxa- exchange the paper instrument for goods and ser- tion, regulatory, or legal significance. Often, this vices. The value of this $100 bill comes from the categorization process makes sense because the four expected economic benefits it can provide to the different categories of intangible personal property owner. (although fundamentally similar) have slightly different economic attributes. These four categories of intangible personal General Intangible Assets property are as follows: The second category of intangible assets includes most other intangible assets that are not elsewhere 1. Financial (working capital) assets categorized. 2. General intangible assets One categorization of general intangible assets 3. Intellectual property follows: 4. Intangible value in the nature of goodwill n Technology-related (e.g., proprietary technology) Financial Assets n Customer-related (e.g., customer lists, customer engineering drawings and techni- Most analysts are familiar with financial assets. For cal documentation relationships, customer a business, financial assets are recorded as “current contracts) assets” for financial accounting purposes. Common n Contract-related (e.g., favorable supplier examples of financial assets include cash, accounts contracts, technology sharing agreements, franchise agreements) n Data-processing-related (e.g., computer software, automated data bases) n Human-capital-related (e.g., a trained and assembled work- force, noncompete covenants, employment agreements) n Marketing-related (e.g., advertis- ing materials, marketing bro- chures and materials) n Location-related (e.g., leasehold interests, mineral or mining exploration rights) n License-related (e.g., operational or environmental licenses or permits, pollution control permits)

6 INSIGHTS • SUMMER 2020 www .willamette .com It is important to note that the above-listed gen- n Excess income—This goodwill component eral intangible asset categories are for discussion is related to income generated by a taxpay- purposes only. They do not represent any particular er’s total unit that is greater than amount categorization for financial accounting, taxation, needed to provide a fair rate of return on all regulatory, legal, or other authority. of the tangible assets and identifiable intangible assets of the total unit. Intellectual Property n Present value of future growth opportuni- ties—This goodwill component is related to Intellectual property is created by human intellec- the expectation of growth in future income tual and/or inspirational activity. Such activity is associated with future assets (both tangible typically specific, conscious, and can be attributed and intangible) that do not yet exist on the to the activity of specific individuals. In contrast, assessment date. other intangible assets are created in the normal course of business operations. In the United States, intellectual property is Generally Accepted Intangible typically registered under—and is protected by— specific federal and state statutes. These statutes Property Valuation give the intellectual property owner specific legal Approaches and Methods rights with regard to commercial development and There are three generally accepted intangible economic exploitation of the intellectual property. property valuation approaches. These valuation These statutes also give the intellectual property approaches encompass a broad spectrum of applied owner the right to prevent other parties from com- microeconomics principles and investment con- mercializing the intellectual property. cepts. Within each valuation approach, there are There are four types of intellectual property: several valuation methods. 1. Trademarks and trade names (e.g., service The three generally accepted intangible property marks, service names, and trade dress) valuation approaches are as follows: 2. Patents (e.g., utility, design, and plant pat- 1. The cost approach ents and the associated patent application) 2. The market approach (sometimes referred 3. Copyrights (e.g., musical and literary com- to as the sales comparison approach) positions, other works of art, and copyrights in computer software and engineering draw- 3. The income approach ings) 4. Trade secrets (e.g., processes, designs, dia- The following discussion summarizes the gen- grams, drawings, schematics, memoranda, erally accepted intangible property valuation etc.) approaches and methods. The discussion is presented in the context of applying the unit valuation principle to value industrial or commercial property. An Intangible Value in the Nature of Goodwill in-depth explanation of each valuation approach There are different definitions (or types) of good- and method is beyond the scope of this discussion. will for transaction, taxation, financial accounting, litigation, and other purposes. For property tax pur- Cost Approach poses, the relevant type of goodwill is often business The cost approach indicates the value of an intan- or institutional goodwill. gible asset as the cost (in terms of current dollar Analysts often refer to business or institutional expenditures) required to create a hypothetical goodwill as intangible value in the nature of good- substitute intangible asset with equivalent utility will. This is because the value of business or insti- and functionality as the actual intangible asset. The tutional goodwill is related to several components. cost components in a cost approach analysis typi- The components of business or institutional cally include direct costs, indirect costs, developer’s goodwill include the following: profit, and entrepreneurial incentive. n Going-concern value—This goodwill com- If the substitute intangible asset is superior to ponent is related to the fact that all of the actual intangible asset, then allowances should the elements of a taxpayer’s total unit are be made for all forms of depreciation (including physically and functionally assembled in physical depreciation, functional obsolescence, and place and ready to use. economic obsolescence) in order to estimate the value of the actual intangible asset.

www .willamette .com INSIGHTS • SUMMER 2020 7 The intangible asset cost approach valuation Income Approach methods include the following: The income approach recognizes the prospective n Reproduction cost new less depreciation revenue, expenses, profitability, and investments method—The total cost, at current prices, associated with the ownership of an intangible asset. to construct an exact duplicate or replica This approach indicates intangible asset value as the of the subject intangible asset, adjusted for present value of future income. depreciation That metric income may be measured as operat- n Replacement cost new less depreciation ing income, net income, net cash flow, operating method—The total cost to create, at cur- cash flow, or some other measure of income, and it rent prices, an asset having equal func- should be estimated over the asset’s expected use- tionality or utility of the intangible subject ful economic life (“UEL”). This expected income asset, adjusted for depreciation stream is brought to a present value by the use of n Historical cost less depreciation method an appropriate market-derived, risk-adjusted rate of (or an alternative method referred to as the return (or capitalization rate). trended historical cost less depreciation The generally accepted intangible asset income method)—Actual historical asset develop- approach valuation methods include the following: ment costs may be identified and quantified n Differential income (with/without) method and sometimes “trended” to the valuation date by an appropriate inflation-based n Incremental income method index factor, adjusted for depreciation n Profit split method (or residual profit split method) The cost approach may have certain application n Residual (excess) income method limitations for intangible assets with unique quali- n Capitalized excess earning method ties. Unlike some fungible assets, certain intangible n Multiperiod excess earnings method assets are not fungible.

Intangible asset income approach valuation Market Approach methods are particularly applicable in situations The market approach indicates the value of an where the intangible asset is used to generate a intangible asset based on valuation pricing mul- measurable (and separately identifiable) amount of tiples derived from arm’s-length sale or license income. transactions regarding either comparable or guideline intangible assets. Typically, individual intangible assets are not bought and sold in fee simple Intangible Property Value interest. Accordingly, individual intangible asset sale Extraction Methods transactional data are not often readily available. Many taxing jurisdictions do not tax intangible prop- However, many intangible assets (such as trade- erty from property taxation. However, property tax marks, copyrights, and patents) are licensed in assessments are sometimes based on the unit valu- arm’s-length transactions. When available, these ation principle, which typically concludes a value transactional data may be used to prepare a market for all of the taxpayer’s operating property (both approach analysis. tangible and intangible). For this reason, the value of intangible property may need to be subtracted The generally accepted intangible asset market from the total unit value. approach valuation methods include the following: There are several methods that may be applied n The sales comparison method to subtract intangible asset value from the unit prin- n The relief from royalty method ciple valuation conclusion. These value subtraction n The comparable profit margin method methods include the following: 1. Direct subtraction method Market approach methods are particularly appli- 2. Transfer price (income allocation) method cable when there is sufficient quantity of comparable (almost identical) or guideline (similar from When selecting an intangible asset value a risk and expected return perspective) intangible subtraction method, the analyst should refer to any asset transaction data. legal precedents or statutes in the subject taxing

8 INSIGHTS • SUMMER 2020 www .willamette .com jurisdiction. In the event the taxing jurisdiction property is not subject to property taxation in the does not have a subtraction standard or precedent, Refinery’s taxing jurisdiction. The Refinery owns the analyst should select the subtraction method internally developed software that is used in its that makes the most sense for the analysis. operations. For simplicity, let’s assume the Refinery For example, the intangible asset may have does not have any other intangible property. no separately identifiable income stream. In such The Refinery retained an analyst to estimate the a case, it would be difficult to deduct a specific value of the internally developed software as of the amount of income from the total unit operating valuation date. Based on this valuation analysis, income in the income approach, as would be the the Refinery will exclude the value of the intangible case with the transfer price (income allocation) personal property (i.e., the internally developed method. software) from the total unit value. Not having an identifiable income stream does To value the Refinery’s software, the analyst not necessary imply that the asset is not an exempt applied the cost approach, replacement cost new intangible asset. The question of whether an intangi- less deprecation method. The analyst concludes the ble asset is taxable or not depends on the particular value of the Refinery software, as of the valuation taxing jurisdiction. date, is $160 million. As presented in Exhibit 1, the valuation syn- Direct Subtraction Method thesis indicates a value conclusion of the Refinery The direct subtraction method is the simplest to total unit of $1 billion. Subtracting the value of understand. There are two factors of the direct sub- the software intangible personal property of $160 traction method: million, yields a residual value of $840 million for 1. the synthesized value of the total unit the Refinery taxable property (i.e., real estate and (based on any/all unit principle valuation tangible personal property). approaches), and In this example, the software valuation analy- 2. the synthesized value of all exempt intangi- sis resulted in reducing the Refinery property tax ble assets (based on any/all intangible asset assessment by 16 percent. valuation approaches)

The concluded value of the intangible assets Exhibit 1 is subtracted from the Assessment Authority’s Valuation of Taxpayer Refinery Total Unit total unit value to conclude the residual value Unit Principle Valuation Approach and Method Value Indication of the taxable property.

Income Approach: Direct Subtraction Yield Capitalization Method [a] $1,100,000,000 Extraction Method Direct Capitalization Method [b] $900,000,000 Illustrative Example Sales Comparison Approach: Let’s assume that the Comparable Sales Method [c] $960,000,000 taxpayer refinery (the “Refinery”) is assessed Valuation Synthesis and Concluded Value of Refinery Total Unit $1,000,000,000 in its taxing jurisdiction based on the unit valu- Concluded Value of Refinery Total Unit $1,000,000,000 ation principle. Let’s Minus: Concluded Value of Refinery Computer Software [d] $160,000,000 assume that the local Equal: Residual Value of Refinery Taxable Property $840,000,000 assessment authority values the Refinery [a] Based on present value of Refinery total net cash flow. total unit of operating [b] Based on direct capitalization of Refinery total net operating income. property at $1 billion [c] Based on comparable sales of operating refineries and market-derived pricing as of the valuation date. multiples. Let’s also assume [d] Based on replacement cost new less depreciation method. that intangible personal

www .willamette .com INSIGHTS • SUMMER 2020 9 Transfer Price (Income Allocation) Summary and Conclusion Method Property owners and assessment authorities often The transfer price (income allocation) method have to consider the value of intangible property. (hereinafter called the “transfer price method”) Some taxing jurisdictions exempt intangible prop- assumes that an economic rent is charged to the erty from property taxation. And, some taxing juris- taxpayer for the use of the intangible assets. dictions tax intangible property for tax purposes. That rent (or “capital charge”) is subtracted from For property tax purposes, the industrial and the total unit operating income. In other words, the commercial property of utilities, transportation, transfer price method makes the assumption that communication, and other similar utility-type prop- if the taxpayer did not in fact own the intangible erties are often assessed by applying the unit valua- assets, it would have to rent those intangible assets tion principle. The unit valuation principle involves from the marketplace at an arm’s-length price. the collective valuation of all of a taxpayer’s oper- The total unit operating income is reduced by this ating property as a single “unit.” For this reason, intangible asset rent. The reduced total unit oper- property tax assessments that are derived using the ating income is included in any income approach unit valuation principle implicitly include the value analysis or any sales comparison approach analysis of the taxpayer’s intangible property. applied to estimate the taxable property value. Since In jurisdictions that do not tax intangible prop- the intangible-asset-related income is excluded from erty, property owners and assessment authorities the total unit operating income, no additional adjust- should ensure that the value of any exempt intan- ment is necessary to subtract the value of the intangible assets from the total unit value. gible property is excluded from the unit valuation principle assessment. If the assessment includes exempt intangible property, the taxpayer should Transfer Price (Income Allocation) identify the intangible assets, value the intangible Extraction Method Example assets, and subtract the value of those intangible In this example, let’s continue using the Refinery assets from the total unit value. as the illustrative taxpayer. Let’s also use the same This discussion focused on the economic attri- assumptions that were applied in the direct subtrac- butes that are necessary for the identification of tion extraction method example. intangible property. Additionally, this discussion In the transfer price method, the analyst will summarized the generally accepted intangible prop- estimate a fair rate of return on the value of the erty valuation approaches and methods. Finally, this Refinery’s computer software. The fair rate of return discussion illustrated two methods for subtracting can be the taxpayer’s weighted average cost of the value of the intangible property from the tax- capital (“WACC”) or some other industry/taxpayer payer’s total unit value. return on investment measure. Let’s assume that the Refinery WACC is 12.5 percent. Notes: If the concluded cost approach value of the 1. Robert F. Reilly and Robert P. Schweihs, Guide to Refinery computer software is $160 million and the Intangible Asset Valuation (New York: American fair rate of return on investment on the Refinery’s Institute of Certified Public Accountants, 2014), 2–3. computer software is 12.5 percent, then the annual 2. Robert F. Reilly and Robert P. transfer price (or economic rent) for the use of the Schweihs, Best Practices: software is $20 million ($160 million multiplied by Thought Leadership in Valuation, Damages, and 12.5 percent). Transfer Price Analysis The Refinery’s operating income is reduced by (Ventnor, NJ: Valuation this “rent” associated with the use of the computer Products and Services, 2019), software. The taxpayer may apply the same Refinery 288. unit principle valuation income approach methods that the assessment authority applied to conclude the Tia Hutton is an associate in our Refinery unit value. Of course, the operating income Portland, Oregon, office. Tia can be included in this income approach analysis is reduced reached at (503) 243-7501 or at by the rent (or arm’s-length transfer price) on the [email protected]. software intangible asset. The result of this adjusted John Ramirez is a managing direc- application of the income approach is a Refinery unit tor in our Portland, Oregon, office. value conclusion that has been implicitly reduced by John can be reached at (503) 243- 7506 or at [email protected]. the value of the software intangible property.

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