Valuing Trademarks in the Context of a

§482 Income Re-Allocation

 

DHL Corporation and Subsidiaries

v.

Commissioner of Internal Revenue

T.C. Memo. 1998-461, 1998 WL 906788

 

 

Mark Chiarello

 

Law and Valuation

Professor Palmiter

Spring 2001

 

 

 

 

             

            Taxation of international business transactions is a complex proposition at best.  But, in the recent case DHL Corporation and Subsidiaries v. Commissioner of Internal Revenue the tax court confused the issue further buy disregarding the applicable regulations.

 

ISSUES

 

RULES

ANALYSIS

            In DHL there was a sale of a trademark from the US corporation DHL to it commonly controlled Hong Kong sister corporation DHLI.  In transactions of this nature there is the potential to evade US income taxes by charging a below market price and shifting income to a foreign jurisdiction.  §482 allows the IRS to combat this type of tax evasion by allocating the income as it would have been if the sale had occurred for an arms length price.  In this case, the Service disagreed with the value that DHL and DHLI set on the trademark and made a reallocation. DHL objected and the matter came before the tax court to determine the proper value.

 

            The treasury regulations provide substantial guidance on the proper way to determine value for intangible assets.  Although the court heard evidence that would have supported a ruling based on the regulatory methods, in the end it chose to invent a method of its own.  Furthermore, in applying its new method, the court made some very questionable financial assumptions.  Based on this novel method the court held that DHL was liable for tax on an additional $80 million of income.  The court also imposed substantial penalties under §6662.

 

            The result of the court’s ruling is to further confuse an already complex issue.  Companies engaging in trademark sales cannot rely on compliance with the regulations to shield them from tax liability.

          I. Introduction

When domestic and foreign companies have common ownership, income shifting between the companies can potentially be a tax subterfuge.  Typically this involves recognizing income in low tax foreign jurisdictions that was really earned in the United States.  §482 of the Internal Revenue Code allows the IRS to reallocate the income and tax the US company appropriately.

 

A simple example will help to illustrate the application of §482:

 

A California corporation (Calco) and a Taiwanese company (Taico) are owned by the same individual (Owner).  Taico manufactures electronic components and transfers them to Calco, which distributes them in the US.  The components cost Taico $1 to manufacture and ship to the US.  Calco incurs $1 each in selling expenses.  The components are sold to the customer for $3.  If Taico transfers the components to Calco for $2, Taico will realize $1 in profit.  If Taico transfers the components for $1 Calco will realize the $1 profit.  Owner gets the profit either way, so he chooses to realize it in Taiwan where he pays minimal tax.

 

In the above example the US government would be deprived of all income tax revenue from Calco’s operations because it allocated profits in a commonly controlled group.  If Taico and Calco were unrelated companies they would have agreed on a price, through an arms length negotiation that presumably would have allowed each of them to realize some of the profit.  The purpose of §482 is to allow the Service to tax Calco on the profit it should have realized by paying an arms length price.

 

            This paper describes a recent tax court decision involving the valuation of a trademark transferred between companies under common control and thus subject to section 482.  DHL Corporation and Subsidiaries v. Commissioner of Internal Revenue, T.C. Memo. 1998-461, 1998 WL 906788.  In the case, DHL sold its trademark to its offshore sister company DHLI.  Although the trademark was not resold to produce a profit, its use in the business of the DHLI generated profits. 

 

          II. DHL v. Commissioner

1.     Background

This case is particularly interesting because it shows the danger of failing to offer coherent fully developed arguments in the alternative.  By relying completely on a single theory, DHL made an all or nothing gamble.  When the court chose not to accept DHL’s primary argument, the court was left to conduct valuation without sufficient guidance. 

A.     History of DHL Companies

In 1969 DHL was incorporated in California and entered the document and small package courier business.  In 1972 DHLI was incorporated in Hong Kong and conducted a similar business in conjunction with DHL.  DHL and DHLI worked together to deliver packages in the US and abroad.  DHL handled US operations, and DHLI handled international operations.  To the customer the companies acted as a single seamless network under the trademark DHL.  From the beginning until the time of the transaction at issue both companied were owned and controlled by the same group of four individuals. 

B.     Transaction with Foreign Investors

In the late 1980’s the owners began seeking a merger partner for strategic reasons, and as a way to monitize some of their assets.  In 1988 they received an initial offer from a consortium of international investors consisting of Japan Airlines Co., Nissho Iwai Corp., and the German airline Lufthansa.  After extensive negotiations the following transaction was agreed upon.

 

      The owners of DHL/DHLI transferred all of the assets of DHLI and the worldwide DHL trademark (subject to a 15-year reservation of the US rights) to Newco.  In exchange they received 42.5% of Newco stock.  The foreign investors paid $284 million to acquire a 57.5% interest in Newco.  This means that DHLI and the DHL trademark were valued at approximately $500 million in total.  For tax $20 million of the price was allocated to trademark value, and DHL recognized revenue in this amount in 1992. 

 

Newco and DHLI continued to work together as a single network for package delivery.  The original owners retained full ownership and control over DHL and were actively involved as directors in Newco.   

 

2.     Issues at trial

The main issue presented at trial was the value of the DHL trademark.  The court had to analyze the value of the DHL trademark sold by DHL to Newco to see if the price paid for it fairly represented an arms length price.  If DHL received less than the full value, than it failed to recognize the appropriate amount of taxable income.  As in the example above, a sale for less than full value would have the effect of shifting income to an offshore company.

 

In addition to the issues of trademark value, the case addressed other issues including imputed royalties for the period prior to the transaction, imbalance and transfer fees for services between DHL and DHLI, and network fees.  While these issues are closely related §482 allocations of income, they do not bear directly on the holding in the trademark issue.

 

A.     DHL Position at Trial

DHL argued that the $20 million allocated to trademark in the final transaction should be given effect because it was in fact an arms length price negotiated between uncontrolled parties.  They offered expert valuations based on the relief from royalty method to support the reasonableness of the $20 million figure 

 

The owners of DHL were involved with Newco both as owners and because of the intention of preserving the operating relationship between the two companies.  Although the total price paid by the foreign investors was the subject of intense negotiation, the record showed that the allocation decision was based on the owners’ desire to minimize tax burdens. 

 

Although the argument that the transactional allocation was in fact arms length had substantial weakness, DHL relied on it heavily.  The opinion indicated that most of the evidence presented was in support of this line of argument.  By failing to articulate coherent arguments based on the regulatory methods, DHL allowed the court to invent its own method. 

B.     IRS Position at Trial

The Service based their argument on expert valuations using the relief from royalty method.  The Service’s experts came up with values of approximately $300 million.  The record shows that a classic battle of the experts ensued as each side argued its relief from royalty based valuation. 

 

The Service also sought to support this value by pointing out that the purchase price included $300 million that was not attributable to tangible assets.  They argued that this entire sum should be allocated to trademark.

 

3.     Regulations

A.     1968 and 1994 regulations

The regulations interpreting §482 are divided in two sections.  §1.482-1A, 2A are the controlling regulations for transactions prior to 1994.[1]  These are the regulations the court cites in the opinion. 

 

The regulations promulgated in 1994 are contained in §1.482-1-8.[2]  These regulations are more clear and explicit in their interpretation of the statute, but they do not represent a significant change.  It is therefore strange that the court allowed the Service to interpret the 1968 regulations in a way that was contrary to the position of the 1994 regulations.  Even more unusual DHL apparently failed to invoke §1.482-1(j)(2), which allows the taxpayer to elect to apply the 1994 regulations retroactively. 

 

As discussed below, the Court’s strained interpretation of the 1968 regulations was disadvantageous to DHL, and will prove to be an unworkable precedent.  The analysis in this paper will address both the 1968 and 1994 regulations in an attempt to fully address this complicated issue.

B.     Valuation Methods

Both sets of regulations agree that the purpose of §482 is to ensure that transactions between commonly controlled entities receive the same tax treatment as similar transactions between uncontrolled entities.[3] 

 

The appropriate standard for evaluating transactions is the “Arms Length Standard”. [4]   This means that the transaction should have the same result as if an uncontrolled entity had negotiated the terms with another uncontrolled entity in an arms length transaction. The regulations discuss several specific methods that can be used to determine what the arms length result should have been.  Although these transactions vary in their specific approach, they are all strongly focused on the importance of basing the valuation on data from actual arms length transactions in the market.

 

The regulations also have guidelines for selecting the method to use.  The 1994 regulations provide the “best method rule” at §1.482-1(c).  This rule requires that the arms length result should be determined using the method that provides the most reliable result.  Factors to consider include comparability of compared transactions, completeness and accuracy of data, and reliability of assumptions.  §1.482-4 specifically addresses the four acceptable methods for valuing transfers of intangible assets.  The comparable uncontrolled transaction method and the unspecified (relief of royalties) methods are the only ones that apply to the facts of this case.  If available, the comparable transaction method is presumed to be most accurate.[5]  

 

The 1968 regulations state simply that the comparable transaction method is preferred, and should be used whenever possible.  It provides other factors to use in determining the price unrelated parties would have charged when there is no directly comparable transaction.  The factor approach basically takes data from relevant but not comparable transactions to estimate a market price for the transaction at issue.  These factors include prevailing industry rates, terms of the transfer, profits the transferee can expect to realize from the intangible, and competing bids for the property.[6]      

 

4.     Holding of the Case

(i) Method used

Although the court considered arguments based on the methods required by the regulations, in the end it’s holding was based on a method largely of its own invention.  The court’s method may be best described as ‘purchase price allocation’.  The value of the tangible assets ($200 million) was subtracted from the sale price ($500 million) to determine the total amount of intangible assets included in the sale.  The court found a total intangible value of $300 million using this method.  The court then allocated the intangible assets among several categories to determine how much of the intangibles should be attributed to trademark.

(ii) Application and result

After lengthy analysis the court found that the DHL trademark that DHL sold should have been valued at $100 million dollars.   The difference between this amount and the $20 million allocated at the time of the transaction was added to DHL’s taxable income for 1992.  

 

 

      III. Analysis of Holding

Of the four methods described in the regulations, two do not appear to apply.  Neither the court nor the parties suggested that they did.  The analysis below will address the two that do apply, as well as the method developed by the court. 

 

1.     Court Method

 

            This court’s allocation of intangibles method is not without merit.  Finding the total value of intangibles is a reasonable starting point for valuing the trademark.  But there are three major problems with the court’s method.  

 

First, the court created unworkable precedent for interpretation of §482.  The opinion does not find fault with the clear regulatory scheme, or discuss why a different method is preferable.  The court simply chose to use its own method, which is in sharp contrast to the regulatory requirement that value be based on market prices.  Compliance with the already complicated  §482 is now much harder.  Practitioners cannot be certain that compliance with the regulations will shield them from liability.  This will have a chilling effect on transactions of this type.  The stakes are quite high.  Not only was DHL liable for tax based on the reallocation; they were subjected to severe §6662(b), (h) penalties based on the court’s valuation.

 

Second, the court’s application of its own method is severely flawed.  Several parts of the court’s analysis show that it failed to comprehend both the underlying business transaction, and the fundamental financial principals.  The method, as applied by the court, could never be used to generate a valid trademark valuation. 

 

The third problem relates to the case at hand.  In the face of a detailed regulatory framework, there was no way to foresee the court’s decision to choose its own method.  The parties were not prepared to make arguments based on the court’s novel method.  For this reason, much of the information needed to support the court’s analysis was not offered at trial.  The court took the evidence offered in support of arguments on the regulatory methods, and cobbled it together with its own assumptions to reach a valuation.

 

Below is an analysis of the factors the court did or should have considered in allocating the total value of intangibles.

A.     Control Premium

The court’s allocation of intangibles should have taken into account the portion of the purchase price that represented “control premium”.    A control premium represents the additional price a buyer is willing to pay for control of a company.  It is above and beyond the value of the assets, tangible and intangible.  Therefore the portion of price attributable to control premium should be subtracted from the total price before addressing allocation of asset price.  Failing to consider the effect of a control premium flaws the court’s application of its own method.

 

It would appear that the price of the transaction at issue included a control premium.  A buyer is willing to pay a premium for control because it believes that it can increase the value of the company by the decisions it makes, or through synergy with its existing operations.  The foreign investors were acting in concert, with the intention of leveraging their existing airline business to add value to DHLI’s package delivery business.  They should have been willing to pay a premium over the value of the assets as currently employed.  Additionally, the case cited by the court defined control premium as the additional price current owners require in exchange for relinquishing control. [7]  The court’s own findings of fact show that the DHL owners repeatedly insisted on a premium for giving up control of DHLI.

 

Several of the expert valuations indicated that a control premium of 40% of the asset value would be appropriate.  This analysis would lead to the conclusion that $143 million of the $500 million total price was for control.  That would leave $357 million in value to be allocated among the assets.  Subtracting the $200 million for tangible assets would leave $157 million to be allocated among the intangible assets.  This is about half the value the court assigned to intangible assets. 

 

Under these circumstances it is hard to understand why the court did not assign any of the purchase price value to control premium, or at least discuss its decision not to.  Because the parties had no reason to expect the valuation method the court chose, they did not present arguments that squarely addressed control price in this context.  Nevertheless, the evidence was available for the court to make specific findings on the issue.  It appears that the court simply did not understand the issue.       

B.     Value of Non-Trademark Intangible Assets

Starting from its $300 million price for all intangible assets, the court split the amount in half.[8]  Although the opinion was not explicit, it appears that one half was assigned to the value of the DHL network.

 

As part of their general argument in support of a low trademark valuation, DHL offered evidence that the intangible value was attributable to the “network”.  This refers to the systems, organizational structure, working relationships and know-how that enable the company to use its physical assets to deliver customers’ packages efficiently.  This is part of the going concern value that causes a functioning business to be worth more than the sum of its assets. 

 

The court agreed with DHL that this was indeed a valuable asset.  But, the court does not go on to make specific findings about the value of the network.   Although there is significant evidence on this issue from both parties, the court seems unwilling to wade in and address individual assumptions and calculations.  It holds simply that the network is “at least as important as the name DHL”.[9]

C.     Value of Trademark

The other half of the price paid for intangible assets was allocated to the worldwide DHL trademark.  The value of the trademark represents the customer relationships and goodwill built up by DHL and DHLI over their history.  The court went on to sub-divide the $150 million in trademark value between the international and domestic rights to the trademark.  Although the trademark itself was the same, the right to use it in a defined geographic region can be separated. 

(i) International Trademark

The court found that two-thirds of the worldwide trademark value was attributable to the value of the trademark outside the United States.  The court said this division was based on the relative profits of DHL and DHLI, but did not address the issue in detail.  Taking two-thirds of the $150 worldwide trademark value gives a $100 million value for the international trademark rights.

 

The court’s analysis up to this point indicated that the international investors had actually paid $100 million dollars for the international rights to the DHL trademark.  Although the analysis had some weaknesses and some gaps, it was essentially logically sound.  The court’s next step was to discount the $100 million by 50% to reflect marketability issues related to a cloud on DHL’s ownership of the international rights.  This is blatantly inconsistent with the method the court had chosen to apply. 

 

A discount for marketability is appropriate when using comparables.  If the DHL trademark were being compared to a trademark that did not have marketability issues, it would be appropriate to make the adjustment to improve comparability.  But, under its stated method the court had allocated the entire purchase price among specific assets.  The implicit assumption is that the international investors paid an arms length price for the whole transaction, and the only issue is allocating the price among the specific assets. There is no justification for the court’s choice to disregard $50 million.  The court’s failure to comprehend the underlying transaction resulted in the creation of unworkable precedent. 

(ii) Domestic Trademark

The Service argued that DHL’s right to use the domestic trademark for 15 years constituted additional taxable income.  This is known as the Alstores problem.  In the Alstores case, Steinway was attempting to sell a building for $1 million.  Alstores purchased the building for $750,000 and allowed Steinway to continue to occupy the building for two years.  The court held that Steinway had received total compensation of $750,00 in cash and $250,000 of lease, all of which was taxable.

 

In the case at hand, the service argued that the transaction consisted of an immediate sale of all worldwide trademark rights.  The compensation received by DHL included cash and a 15-year royalty free license, both of which were taxable.  

 

The transaction can also be viewed as a sale of international rights effective immediately, and a sale of domestic rights effective after a 15-year reservation.  This was the treatment DHL was seeking, and the transaction documents were drafted in the form of a “reservation of rights”[10] If the court found the transaction to be a reservation of rights, there is no Alstores problem.  The foreign investors would have paid cash for the package of current and future rights that they received.  The §482 allocation would have fixed the amount of cash to be attributed to the trademark.

 

            Unfortunately the court fails to fully grasp the significance of this issue and address it in a logically consistent manner.  The court accepts the Service’s contention that the transaction was an immediate sale of all rights.  This means that the 15-year royalty free lease must be accounted for as income to DHL.  It then states the Alstores problem does not exist because the§482 income adjustment will take into account the full value of the trademark sale and tax DHL accordingly.  This would be true if the trademark value was set independently of the transaction.   Unfortunately, the court forgets that its valuation of the trademark is based on an allocation of the cash payment made by the foreign investors.  The royalty free lease remains an additional and untaxed item.  Again, the court’s lack of understanding creates an inaccurate valuation in this case, and an unworkable precedent for the future.

 

2.     Comparable Uncontrolled Transaction

Both the 1968 and 1994 regulations state that the preferred way to find the arms length result is to look at the result of a similar transaction between uncontrolled parties.[11]  

 

The record shows at least one comparable transaction that could (and should) have been used as a basis for valuation.  From 1986 thru 1989 DHL was engaged in negotiations with UPS.  UPS was seeking to acquire the business as a going concern and incorporate it into their existing operations.  They wanted to use the DHL assets and network relationships under their own name.  In 1987, UPS made a final offer to acquire a majority of the assets of DHL and DHLI (with the exception of certain specific physical assets).[12]  This is solid market-based evidence of what a willing buyer would have paid for the specific assets involved in the transaction at issue.  It is particularly compelling to note that the comparables approach is the preferred method even though it usually involves a similar transaction involving a completely different company and set of assets.  Here a firm offer on the assets in question was disregarded as a source of evidence.

 

Of course adjustments would have to be made to get a directly comparable price.  §1.482-1(d)(2) states that adjustments to improve comparability should be made.  The basic adjustments to separate out the DHLI portion of the price and account for increase in value from 1987 to 1990 are relatively simple.  Additionally, §1.482-1(d)(3) provides guidelines for making more subtle adjustments based on the differences in how the comparable and actual purchaser would have used the assets.  In this case few of these adjustments would have been necessary as UPS intended to continue similar operations.

 

The court completely dismissed the arms length UPS offer as not comparable.  Because UPS planned to substitute its own trademark for that of DHL in ongoing operations, the court reasoned that the offer price essentially disregarded the value of the DHL trademark.[13]  Apparently the court failed to recognize the implications of this finding.  The UPS offer presented an arms length value for all assets (tangible and intangible) with the exception of the trademark.  The total price paid by the foreign investors in the actual DHL transaction was an arms length price for all assets including the trademark.  By subtracting the UPS offer price from the foreign investors’ price one can determine precisely the amount that can be attributed to the trademark.  The additional price paid by the foreign investors must be allocated to trademark.

 

DHL failed to fully develop this argument as a comparable method valuation.  In fairness to the court, the record does not show that DHL presented a coherent argument for a comparables based valuation.  DHL offered the evidence on the UPS offer to support a generally low valuation as part of their primary argument that the contract price was in fact arms length.

 

3.     Unspecified Method

The parties and the court agreed that the other specific methods for valuing intangibles, comparable profits and profit split, were not applicable to the facts of the case.[14]  This leaves the unspecified method is the only other approved method that is relevant to this case.  This method provides standards for developing a method particular to the facts of the case.

 

The unspecified method “should provide information on the price or profits that the controlled taxpayer could have realized by choosing a realistic alternative to the controlled transaction.”[15]  The ‘relief from royalty’ method meets these criteria because it values DHLI’s purchase of the trademark by discounting to present value the royalties DHLI would have had to pay to license the trademark from DHL.  It is also consistent with the 1968 option of basing value on “prospective profits to be realized or costs to be saved by the transferee by its use” of the trademark.[16]

 

This method is also favored in valuing intangibles because it is consistent with statutory language known as the “superroyalty” provision.[17] §482 states, “in the case of any transfer (or license) of intangible property …  the income with respect to such transfer or license shall be commensurate with the income attributable to the intangible.”  The relief from royalty method complies with this by basing the price DHLI should have paid on the royalty income DHL would have received had they retained ownership.   

 

Both DHL and the Service offered extensive expert testimony giving valuations based on the ‘relief from royalty’ method.  Needless to say, the conclusions of the experts differed dramatically.  The court examined these expert valuations and concluded that the wide disparity in value was the result of differing assumptions about growth of revenue, royalty rate and discount rate.[18]   The court then concluded that it was not bound to accept the conclusions of one side or the other.  It was free to make specific findings and draw its own conclusions.  It is in fact common for courts ruling on discounted cash flow valuation issues to combine different assumption from each side in reaching their own conclusion.

 

In this case the court did something else entirely.  The court stated that it found the Service’s assumptions reasonable, and accepted their estimate of the present value to DHLI of future royalty payments.   But it did “not agree that the value they have determined could be isolated as being attributable to the trademark”.   In holding thusly, the court is saying that income from trademark royalties is not attributable to the licensing of the trademark.  It is difficult even to speculate on what the court could have meant by this statement.  It raises the issue of whether the court really understood the business transaction underlying this valuation issue.  

 

 

 

     IV. Conclusion

In this case, DHL chose to rely entirely on a single argument.  They argued forcefully that the $20 million allocated in the transaction was a valid arms length price for the trademark.  By failing to fully develop other arguments for valuation based on the regulatory methods DHL allowed the court to develop its own valuation method without guidance. 

 

In developing and applying its own method, the court ignored both the regulations and the basic principals of finance.  It appears that the court was simply overwhelmed by the complex evidence.  It grasped at the most easily understood number presented (total price – tangible assets) and manipulated it to reach a result that was close enough to what the parties wanted that they would be unlikely to appeal.

 

The resulting precedent is unworkable in two major ways.  First, by ignoring the regulations the court has reduced predictability.  Corporations engaging in similar trademark sales in the future cannot be confident that adherence to the standard set by the regulations.  Second, the method that the court invented is internally flawed.  Because of the court’s limited grasp of the situation, it created a method that can not possibly yield a correct value by anything other than coincidence.  One can only hope that the Service subsequent courts will simply ignore this flawed ruling.

 

 



[1] 26 CFR 1.482-2A, 2B (1968)

[2] 26 CFR 1.482-1-8 (1994)

[3] 26 CFR 1.482-1A(b)(1) (1968), 26 CFR 1.482-1(a)(1) (1994)

[4] 26 CFR 1.482-1A(b)(1) (1968), 26 CFR 1.482-1(b)(1) (1994)

[5] 26 CFR 1.482-4(c)(2)(ii) (1994)

[6] 26 CFR 1.482-2B(d)(2)(ii),(iii) (1968)

[7] Phillip Morris Inc. v. Commissioner, 96 T.C. 606, 628 1991 WL 51559 (1991)

[8] T.C. Memo 1998-461 p39

[9] T.C. Memo. 1998-461 p36

[10] T.C. Memo 1998-461 p18

[11] 26 CFR 1.482-2A(d)(2)(ii) (1968), 26 CFR 1.482-4(c)(2)(ii) (1994)

[12] DHL Corporation and Subsidiaries v. Commissioner of Internal Revenue. T.C. Memo 1998-461; WL 906788 (U.S. Tax Ct.)  p14

[13] T.C. Memo 1998-461 p37

[14] §1.482-4(a) (1994)

[15] §1.482-4(d) (1994)

[16] 26 CFR 1.482-2B(d)(2)(iii)(g) (1968)

[17] Leonard Schneidman, On the Mark: Transfers of Trademarks and Their Tax Consequences.  14 NO. 3 Prac. Tax Law. 5 (Spring, 2000)

[18] T.C. Memo. 1998-461 p38