Performing valuations for taxation purposes; process, methods and certainty

Introduction

Valuations play a crucial role in the realm of taxation, enabling tax authorities, companies and individuals to determine the value of a company, an asset or a liability. Valuations can be performed for various taxation purposes, including for corporate income tax (“CIT”) and transfer pricing (“TP”) matters. For instance, relating to mergers & acquisitions (“M&A”), share option plans and employee participations become relevant. Discussions on tax valuations between the Dutch tax authorities (“DTA”) and taxpayers are becoming more common in the Dutch tax landscape. To mitigate this risk, we see two options, (i) obtaining certainty in advance by retrieving a tax ruling or (ii) a ‘file and defend strategy’. In this article, we aim to provide a comprehensive overview of the valuation process for tax purposes.

We will first describe the process of performing a valuation. Secondly, we will provide a brief overview of the main valuation methods, including some of the advantages and disadvantages. Additionally, we will link the value concept with the arm’s length principle (“ALP”). Furthermore, the article will explain the possibility of obtaining certainty (in advance) in relation to valuations and we will provide several key takeaways.

The first step in the valuation process is spotting a potential tax valuation dilemma. For taxpayers, tax valuations are driven by determining a potential tax charge. For the DTA and other tax authorities, the goal of closely reviewing tax valuations relates to protecting the jurisdiction’s tax base from eroding. If, for example, as a result of a set of transactions, an asset or liability is transferred between party A and party B, for tax purposes this asset or liability needs to be transferred at an arm’s-length price. Other examples which will require a tax valuation are:

• Transfer of a business or a business restructuring
• Employee Stock Option Plan
• Management Participation Plan
• Transfer of intangible assets
• Transfer of liabilities
• Impairment testing
• Business succession
• Emigration and remigration
• M&A
• Negotiations and or disputes

One of the most important aspects in tax valuation is substantiation and defense. Different from commercial valuations in which one may prepare a valuation for internal purposes only, tax valuations are primarily prepared to substantiate a tax position and to create a defensible position in a tax return. As background, only in case a tax position is defensible will a taxpayer have penalty protection. However, also in case there is a defensible position there is a possibility that the DTA can challenge a tax position. It is therefore very likely that a tax valuation is exchanged to and reviewed by the DTA. In this sense, it is important that the valuation is based on objective en reviewable parameters (also adhering to the ALP). A valuation practitioner preparing a tax valuation must therefore have an understanding of the ALP and should be able to advise and guide a taxpayer in making the right judgements in the tax valuation to ensure that a defensible position is created and that the risk of a challenge by the DTA is limited.

Standard of value

In case an asset or liability is transferred between related parties, the ALP mandates that parties transact in an arm’s-length manner. This means that the commercial and financial conditions which are imposed between related parties should not differ from the commercial and financial conditions which are imposed between unrelated parties. However, arm’s-length conditions may mandate a different transfer price compared to the underlying book value (i.e., accounting costs which are usually depreciated during the economic lifetime of the asset). Hence, a valuation may be needed to determine the arm’s-length price.

Before preparing a valuation, one needs to understand the valuation standard. In the Netherlands, the valuation standard for tax valuations is “waarde in het economische verkeer” (“WEV”). The Dutch High Court describes WEV as follows: “the assumed value or price concluded in a transaction conducted in the most advantageous manner and offered by the highest bidder.”¹

Another valuation standard which is used interchangeable by practitioners and the DTA is the widely known term fair market value (“FMV”). However, slightly different from WEV, the formal definition of FMV is: “the price a product would sell for on the open market assuming that both buyer and seller are reasonably knowledgeable about the asset, are behaving in their own best interests, are free of undue pressure and are given a reasonable period for completing the transaction.”

Based on both definitions, a slight deviation in value may occur between both value standards, as WEV seems to suggest that it equals the price that the highest bidder would pay while FMV only refers to knowledgeable parties. In practice, not much consideration seems to be given to this aspect and definitions are used interchangeably. In this article, we will therefore use FMV as reference for the standard of value.

FMV works well in liquid economic conditions considering the definition described. However, both definitions may provide theoretical difficulties when valuing businesses or assets in case of illiquid conditions (e.g., it may be difficult to determine the highest bidder for an illiquid asset). However, for tax purposes, a certain price must still be determined.

Additionally, the Dutch TP Decree² prescribes that the determination of an arm’s-length price should be performed from the perspective of all parties involved in the transaction. The arm’s-length price will lie between the value from the seller’s perspective and that of the buyer’s perspective (unless the value from the perspective of the seller is higher than from the buyer). The concept of a dual perspective in combination with the standard of value gives rise to the question of what context should be used and whether a valuation of the FMV should include ‘synergies’³ or whether the ‘as is’ or ‘stand-alone’-value should be considered. Based on both aspects (i.e., the valuation standard and the dual perspective), it seems that in theory the synergetic value should be used for tax purposes. However, in practice it might be difficult to reliably estimate the synergetic value of an enterprise without knowing or having a potential buyer (as for most tax valuations, there is no ordinary commercial M&A process). Therefore, in absence of an approach to reliable estimate synergies, one may conclude to use the ‘as is’ or stand-alone’ value for tax purposes.

Valuation methods

There are three basic valuation methods to establish the FMV of a company, an asset or liability for taxation purposes:

1. Market method;
2. Cost method; and
3. Income method.

Each of the above methods has its own advantages and disadvantages. Below, we have provided a high-level overview.

Market method

The market method provides an indication of value by evaluating the price at which the same business or asset, or a similar business or asset, has been exchanged between willing buyers and sellers. Use of the market method requires that information about comparable transactions is available, e.g., recent sales prices of the same or similar asset in a transaction.

The advantages of the market method could be:

• simplicity – certain objective data of market prices may be easily accessible, and
• objectivity – it uses data that is real and public, and it is not dependent on subjective forecasts.

However, disadvantages of this method could be:

• scarcity of market data – market data of rarely traded assets may not be available or only available via paid subscriptions.
• comparability – the use of market data requires a high amount of comparability with the asset being valued.

Cost method

The cost method measures the value of an asset based on costs accumulated. Examples are historical cost or cost to date, replacement costs (i.e., the cost to reconstruct or replace it with another similar asset). The cost method is based on the principle that costs provide a good indication of the value added by its owner. The cost method is strongly correlated to the accounting value of a certain asset or liability (as for accounting purposes, book values are usually based on the underlying costs minus depreciation and amortization). The cost method can be useful to evaluate certain specific assets, such as industrial assets, machinery and certain intangible assets for which no reliable market or forecast information is available and other valuation methods are difficult to apply.

Also, in case it is assessed that no material or substantial value is created besides the costs included for accounting purposes, the cost method may be a very reasonable method to value a certain asset or liability.

Income method

The income method measures the value of a business or asset by the present value of its future economic benefits. These benefits can include earnings, cost savings and proceeds from the businesses or asset’s disposition.

The income method comes in a variety of forms, of which the discounted cash flow (“DCF”) method is the most widely used and known. Based on the DCF method, the value of an asset equals the present value of the expected cashflows on the asset, discounted at a rate that reflects the riskiness of these cashflows. This valuation method projects the net amount of cash flows that a firm or asset will generate from operating and investing activities over a number of years in the future. The DCF method captures all the elements that impact the value of an asset in a comprehensive manner. There are three main components in the DCF method:

1. Explicit forecast of future cash flows (usually a period of five years);
2. Assumption of the terminal future cash flow, and
3. The discount rate at which future cash flows are discounted to their present value.

From a theoretical point of view, the DCF is arguably the most precise method to determine the FMV. The DCF method is forward-looking and depends on future expected cashflows rather than historical results or accounting metrics such as revenue, EBITDA, EBIT or Net Income. However, the DCF method also provides its user with a lot of challenges as a lot of variables need to be included in the model. In the process of preparing a DCF, a mistake is easily made. Examples of commonly made mistakes include, but are not limited to:

• Mismatch between cash flows and discount rate;
• Unrealistic reinvestment assumptions;
• Double counting risks in discount rate and cashflows;
• Too short forecast horizon (stopping the explicit forecast before steady state);
• Mismatch between depreciation and capital expenditures in terminal value;
• Wrong assumption on the convention of cashflows;
• Incorrect inflation assumption in capital expenditures;
• Growth gap between explicit forecast period and terminal value;
• Unrealistic terminal growth assumptions; and
• Forgetting to discount the terminal value cash flow.

The Dutch TP Decree⁴ mentions that valuation methods, in particular the DCF method, may be used by taxpayers and the DTA as part of the five TP methods (i.e., comparable uncontrolled price method, resale price method, cost plus method, transactional net margin method and transactional profit split method)or as a valuation method that can be used to determine an arm’s-length price. In practice, we experience that in most cases, when determining the FMV of an enterprise, a DCF-valuation is asked for by the DTA.

Selection of method

The OECD Guidelines⁵ do not prescribe the use of a specific method when performing a valuation. However, the OECD Guidelines do mention that one should aim at finding the most appropriate method for a particular case. For this purpose, the selection process should take account of:

1. The respective strengths and weaknesses of the methods;
2. The appropriateness of the method considered in view of the nature of a transaction;
3. The availability of reliable information;
4. The degree of comparability between controlled and uncontrolled transactions; and
5. The reliability of comparability adjustments that may be needed to eliminate material differences between controlled and uncontrolled transactions.

Furthermore, the OECD Guidelines state that no single method is suitable in every possible situation, nor is it necessary to prove that a particular method is not suitable under the circumstances. In some cases, the selection of a method may not be straightforward, and more than one method may be initially considered. However, generally it will be possible to select one method that provides the best estimation of an arm’s-length price. However, for complex cases, where the outcome of one method might not be conclusive, it may still be necessary to use various methods in conjunction. For example, when performing a valuation of an enterprise, it may be helpful to use the income method (i.e., a DCF-valuation) in conjunction with the market method (i.e., trading and transaction multiples). Also, it is our experience that the DTA prefers the use of a DCF when valuing an enterprise.

Ruling

In some cases, the DTA offer the option to obtain certainty in advance on a tax position by concluding a tax ruling (or when referring to an arm’s-length price, an Advanced Pricing Agreement). The advantage of a tax ruling is that it provides certainty and avoids potential future disputes with the DTA (which may trigger double taxation, additional costly discussions and/or interest on unpaid taxes). It is also possible to include the outcome of a valuation in a ruling to gain additional certainty on a tax position. To retain a tax ruling, a taxpayer should fulfill certain conditions. These conditions are included in the Decree on tax rulings⁶. For example, sufficient economic nexus must be in place and the saving of Dutch or foreign tax may not be the sole or decisive motive for carrying out the (legal) act(s) or transactions for which a tax ruling is being retained. Based on the Dutch tax ruling Decree, the maximum term of a tax ruling is five years.

A more recent trend is the focus of the DTA on the arm’s length nature of valuations prepared by Dutch taxpayers (or their advisor). This led to the origination of the Nederlands Business Valuation Team (“NBVT”) of the DTA. The NBVT includes registered business valuation specialists and can be contacted for tax related valuation discussions. Additionally, it has become common practice that members of the NBVT review tax rulings which have a substantial valuation aspect. When it comes to obtaining a tax ruling for these cases, taxpayers should be prepared to have a thorough valuation report in place to substantiate their tax position (e.g., for obtaining a tax ruling in relation to a Management Participation Plan). Where possible, the NBVT prefers the application of the DCF method instead of merely using a multiple valuation. Also, when applying the DCF method, the taxpayer should provide explicit substantiation on how it has determined the discount rate and the respective free cashflows. Additionally, for structures which have a valuation aspect but for which no tax ruling is obtained, it is equally important for a taxpayer to have a thorough valuation report available in its records.

We note that these tax rulings must be concluded within the framework of Dutch tax laws, regulations, policy and case law. Furthermore, tax rulings with international characteristics will be made publicly available (albeit summarized and anonymized) and an exchange ruling form will be exchanged with the other (foreign) tax jurisdiction.

Historically, Dutch taxpayers have often agreed tax rulings with the DTA. The ruling, as formalized in the settlement agreement, cannot be overturned or challenged afterwards (e.g., in the event of new insights or case law). A settlement agreement is, in principle, binding on the taxpayer as well as the DTA. However, the settlement agreement may be subject to critical assumptions on the relevant circumstances. It is therefore recommended to review the relevant circumstances throughout the term of the ruling.

Conslusion

This article aimed to provide a wide overview of the valuation landscape for Dutch tax purposes. The standard of value used in tax valuation is WEV or FMV. Dutch tax regulation does not mandate a specific valuation method when performing a valuation. However, in most cases, the DCF seems to be used as the primary valuation method. Ultimately, it is up to the taxpayer, based on the information available to him or her, to substantiate that the method used is the best method to determine the FMV. Also, to increase certainty and to limit risks, a taxpayer may consider a tax ruling. However, when filing a ruling request, a taxpayer must be prepared to have a thorough valuation report available in his books.

Questions?

In case of questions, please contact Joris Steunenberg for more information.

1. BNB 1969/63 ↩︎
2. Dutch Transfer Pricing Decree published by the Dutch State Secretary of Finance, dated 19 June 2019, nr 2019/13003, par. 3.3, page 9. ↩︎
3. Loosely defined as the creation of additional value through combining two or more enterprises ↩︎
4. Dutch Transfer Pricing Decree published by the Dutch State Secretary of Finance, dated 19 June 2019, nr 2019/13003, par. 3.3, page 9. ↩︎
5. OECD Transfer Pricing Guidelines, Chapter II, “Transfer Pricing methods”, par 2.2, page 93. ↩︎
6. Dutch Decree pre-consultation tax ruling with an international charecteristic, dated 18 June 2022 ↩︎