Valuation Insights, Fourth Quarter 2015
Read Valuation Insights, Fourth Quarter 2015
On October 5, 2015, The Organization for Economic Co-Operation and Development (OECD) released its final Base Erosion and Profit Shifting (“BEPS”) project deliverables. The OECD’s BEPS project focused on providing guidance on a wide range of international tax matters that could be adopted into domestic tax. It is intended that this guidance will reduce or eliminate opportunities for multinational enterprises (“MNEs”) to engage in BEPS behaviors that misalign income recognition and value creation. One of the focal points of the BEPS project was overhauling certain areas of the OECD’s transfer pricing guidelines to eliminate the opportunities to achieve BEPS through transfer pricing practices. The OECD’s BEPS project commenced in September of 2013, and the final reports and associated guidance revisions benefitted from substantial written public commentary and public consultations on the discussion drafts. Duff & Phelps participated actively in both of these opportunities for public input.
Some of the most important revisions to the OECD’s transfer pricing guidelines arising from the BEPS project include:
- Changes to documentation guidance so that MNEs are required to file a Country-by-Country reporting (CbCR) template which will provide tax administrations with metrics on income recognition and activity around the world.
- A new documentation standard that would require the creation of a global masterfile giving an overview of the company’s operations and certain critical information about intangible ownership as well as local files which would provide specific details relevant to the evaluation of transfer pricing in each country in which the company operates. This structure is intended to give tax authorities a broader view of the business through access to the global masterfile.
- Major changes to the treatment of risk allocation within a company for transfer pricing purposes. Once these new guidelines become effective in relevant domestic tax laws, they will limit the opportunities for companies to substantially reduce taxes through the contractual allocation of risk to entities in low tax jurisdictions that have minimal personnel. The new guidelines hold that contractual risk allocations will be respected only when the entities contractually assuming the risk have the financial capacity to assume it and have control over the risk they are assuming. Control, under the revised guidelines, requires the capacity to make decisions about whether to take on risk and how to mitigate that risk, as well as actually performing the relevant decision making.
- Inclusion of provisions that would permit, under the right circumstances, tax administrations to make adjustments to the consideration paid for “hard-to-value intangibles” based upon realized results.
- Changes to the guidelines for cost contribution arrangements for intangible development that align with changes around risk assumption and hard-to-value intangibles discussed above.
In addition to these changes to the transfer pricing guidelines, another indirect change to the transfer pricing guidance on interest payments came through the report on Action Item 4 – Limiting Base Erosion Involving Interest Deductions and Other Financial Payments. This report recommends an approach to limiting the opportunity for BEPS through intercompany financial transactions by limiting the deductibility of net interest expense. Specifically, it recommends that net interest expense deductions be limited to a fixed proportion (the recommended range is 10 to 30 percent) of each entity’s EBITDA. The report suggests that alternatively, countries could adopt rules that set limits based upon the consolidated group’s interest expense/EBITDA ratio. The report specifically notes that further work will be done to develop appropriate guidance for banking and insurance companies.
The documentation-related aspects of the BEPS project will have the greatest impact in the very near term, because many countries have already announced that they have or will be revising domestic documentation requirements to include CbCR requirements for companies larger than given size thresholds for tax years beginning after January 1, 2016. The masterfile/local file documentation structure is also likely to be widely adopted.
The actual effects of the other changes will take longer to assess. The U.S. Treasury Department, for instance, seems to believe that the changes to the OECD guidance do not require any material changes to the regulations under Section 482, but it is unclear whether the administration of the regulations might substantively change as a result of the BEPS deliverables. It is clear that some countries came into the BEPS process looking to gain a larger piece of the global corporate tax pool, and there are areas where the guidelines are vague enough to allow tax administrations to take positions that may lead to an increase in double taxation, and consequently, an increase in mutual agreement procedure cases to resolve those double tax incidences where tax treaties exist.
In the coming weeks, Duff & Phelps will be releasing its annual 2015 U.S. Goodwill Impairment Study (the “2015 Study”). Duff & Phelps and the Financial Executives Research Foundation (FERF) first published the results of their comprehensive Goodwill Impairment Study in 2009. Now in its seventh year of publication, the 2015 Study continues to examine general and industry goodwill impairment trends through December 2014, as well as reporting the 2015 results of the annual survey of Financial Executive International (FEI) members. This year’s edition of the study has been expanded and now includes 8,705 publicly-traded companies (compared to 5,153 in 2013), providing a more comprehensive summary of goodwill impairment in the U.S.
Goodwill Landscape and U.S. Goodwill Impairment Trends
Deal activity (based on transactions involving a controlling interest of 50% or more, acquired by U.S. incorporated publicly-traded companies) saw an increase in both volume and value in 2014. The number of closed deals grew by 9% and the deal value increased by a steep 62%, contributing to a slight increase in goodwill added to balance sheets, from $152 billion in 2013 to $157 billion in 2014.
U.S. public companies recorded $26 billion of goodwill impairment (“GWI”) in calendar year 2014, representing an 18% increase from the $22 billion in 2013. Likewise, the number of GWI events increased from 274 to 341 over the same period. Average GWI per event decreased slightly from $79 million in 2013 to $75 million in 2014. Industries that recorded an increase in GWI in 2014 include Energy, Consumer Staples, Financials, Information Technology and Industrials, with Energy registering the largest increase in impairment from $2.1 billion (2013) to $5.8 billion (2014).
Two of the top five largest impairment events of 2014 were in Energy, driving up the total for the industry. In fact, the impact of Energy on the overall 2015 Study was very pronounced: if Energy were excluded from 2013 and 2014, the aggregate GWI trend would have been flat.
2015 Survey of FEI Members
During the summer of 2015 an electronic survey on goodwill impairments was conducted using a sample of FEI members representing both public and private companies to gain insight on GWI and members’ views on related topics. The 2015 Survey continued to monitor FEI members’ use of the optional qualitative test when testing goodwill for impairment (a.k.a. “Step 0”).
Notably, the 2015 Survey demonstrates record use of the Step 0 test since the option first became available. Specifically, 29% of public companies opted to use Step 0 in the 2013 Survey, increasing to 43% in the 2014 Survey, and based on the 2015 Survey, the majority of public company respondents (54%) are taking advantage of the simplified test. Private companies show a similar trend as they continue to embrace Step 0: 40% of respondents currently apply it, which is nearly double the rate in the 2013 Survey (22%).
Two-thirds now believe that Step 0 meets its stated objective of reducing costs, a significant increase from 50% in the 2014 Survey. In addition, nearly half of those that have never applied Step 0 will consider its use in the future.
Specially featured in this year’s edition is an article addressing developments in a number of sectors within the Energy industry. Plummeting oil prices have significantly impacted the Energy industry, leading to substantial goodwill and asset impairments during 2014. Aggregate goodwill, reserves, and other asset impairments in the E&P sector increased from $17 billion in 2013 to over $41 billion in 2014. However goodwill impairment represented less than 10% of the total charges recorded.
Recent Developments in Goodwill Accounting
The FASB is currently reconsidering the accounting for goodwill for public business entities and not-for-profit entities. In an effort to simplify the goodwill impairment test, at its October 28, 2015 meeting the FASB decided to proceed with this project under a phased approach. The first phase is to simplify the impairment test by removing the requirement to perform a hypothetical purchase price allocation when the carrying value of a reporting unit exceeds its fair value (“Step 2” of the impairment model in current U.S. GAAP). In the second phase of the project, the FASB plans to work concurrently with the IASB to address any additional concerns about the subsequent accounting for goodwill.
“Now you see it… now you don’t!” isn’t reserved for the world of magic any more. The world today has become increasingly complex and while technology and a general push toward transparency has made many aspects of our lives easier, today’s markets seem to find new ways to test well thought out and implemented valuation processes and procedures. One area where historically we’ve been able to have confidence in the reliability of “the system” or “the market” is around the pricing of Level 1 assets (actively traded securities).
Globally, we are seeing that a liquid security which was bought in the past and has had a reliable public price every day since might not be so reliable going forward. From June 29 to August 3, 2015, the Greek Stock Market was closed due to the country’s well publicized funding and liquidity challenges. While the Greek market declined 23 percent in value during this time, fortunately, the suspension of trading was a result of macro issues and was anticipated. Asset managers with holdings traded on the Greek exchange were able to plan, to some extent, for the lack of trading and therefore the lack of observable prices to value investments. But disappearing prices are not always systemic; they can be isolated and unexpected. One of the most famous idiosyncratic historic delistings or trading suspensions was that of Lehman Brothers (delisted by the NYSE on Sept 17, 2008). Lehman’s troubles were known for days and even weeks before the International Swaps and Derivatives Association had a special trading session on a Sunday relating to a planned Lehman bankruptcy filing later that day. Other delistings often come as more of a surprise – without the well-publicized issues such as those leading to Lehman’s delisting.
Over the past few years, there have been delistings in China over frauds and accounting irregularities. Most recently, with the significant decline in the Chinese stock market, numerous securities’ trading has been suspended by the government. Both a suspension and a delisting clearly create a pricing issue on the date of the event and thereafter, although the challenges to determine a reasonable fair value estimate can be very different. With a suspension, one might reasonably believe the available financial results for the company to still be a reliable input into the valuation process. In the case of a bankruptcy or fraud, the reliability of the investee company’s financial results may be highly suspect.
Some have used a macro “index” approach to determining fair value when the underlying company is healthy, but the market is not open or trading has been suspended for reasons unrelated to the portfolio company itself. For example, some have used the movement in prices of ETFs or ADRs for the industry, country, and/or related securities as a basis for determining the fair value of the suspended securities. Such an approach may be acceptable, in certain circumstances, for a short period of time after the suspension of trading, but would likely not be appropriate over a longer term.
However, in the event of a bankruptcy or fraud-induced delisting, or when trading has been suspended for an extended period, (more than a month or two) valuation becomes more difficult. Rather than using macro index indications of value, fair value must be determined using so called level 3 (unobservable) inputs. Such a valuation may be difficult as the level of confidence in financial information (especially in the event of fraud) is low and in the event of bankruptcy uncertainty around the value of assets is compounded by the uncertainty around the outcome and timing of the bankruptcy process. In both cases, there is a secondary market for these interests, but pricing tends to be “opportunistic” and difficult to establish “willing buyer/willing seller” as is the premise under the “Fair Value” concept. Therefore, informed judgement combined with a rigorous approach to valuation is required.
Bottom line: investors that report the fair value of securities need to be vigilant in monitoring market conditions especially with respect to securities traded in markets or on exchanges where suspension could occur. In most cases suspended securities will need to be valued using level three inputs and a market and/or income approach. Securities where trading has been suspended because of accounting irregularities, fraud or bankruptcy will likely require extra scrutiny in coming to a fair value estimate. Even when the underlying company is healthy, when trading has been suspended — such as for government policy purposes — fair value would be estimated similar to any other private, non-traded, entity.
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