Use of DCF in a Transfer of Tobacco Distribution Rights

In two prior blog posts, I addressed the use of the discounted cash flow (DCF) to estimate the value of transferred intangibles. The November 25, 2022 post entitled “Valuing Brands Using a Discounted Cash Flow Approach” discussed an October 27, 2022 decision by the French Conseil d’Etat involving the transfer of certain brands from Coverguard to its Luxembourg affiliate. Sacla SA v. Ministre de l'économie considered several applications of the discounted cash flow (DCF) model as well as historical cost-based approaches, where the tax authority asserted a valuation exceeding €20 million while the taxpayer asserted a valuation of only €0.5 million. The January 20, 2023 post entitled “Valuation of Software: CA Software Israel Ltd: discussed an October 2022 decision by the Tel Aviv District Court that supported a challenge by the Israel Tax Authority where the issue was the value of certain software obtained during an acquisition.

A December 15, 2023 ruling by the North Holland District Court involved the transfer of certain distribution rights from British American Tobacco Exports B.V. to British American Tobacco UK Limited. The ruling decided that the value of certain transferred “residual profits” was almost £1.7 billion, which was based on a very elementary application of DCF. An earlier blog post noted two other issues involving British American Tobacco – intercompany guarantee fees and an intercompany factoring arrangement.

DCF approaches critically depend on the assumptions with respect to the economic useful life of the intangible asset, projected sales, what represents a reasonable royalty rate, any expenses borne by the owner of the intangible asset, and the appropriate discount rate. The DCF model used by the Dutch tax authorities assumed an infinite useful life. A simple version of DCF would estimate the value (V) of an intangible brand as:

V = Ct/(r – g)

where Ct = the cash flows from the intangible asset, g = the steady state growth rate of these cash flows, and r = a reasonable discount rate. The court’s ruling assumed that the growth rate was zero and that the discount rate was 7%, which would imply that the value equals 14.2857 times the cash flows attributable to the transferred intangible assets. Cash flows were assumed to be £118.889 million per year so the court concluded that the value of the transferred intangible assets equals £1698.4 million.

This note briefly discusses whether the assumptions with respect to the 7% discount rate and the zero growth rate for cash flows were reasonable. The main purpose of this note, however, is to note that the assumed cash flows must be derived from a statement of the transfer pricing policies and whether these policies are consistent with the arm’s length standard.

Discount Rate and Growth Rate

The Dutch tax authorities selected a 7% discount rate, which British American Tobacco used for internal accounting purposes. The representatives of British American Tobacco objected, arguing that the appropriate discount rate for valuations of transferred intangible assets should be higher. The court disagreed with this reasoning and accepted the 7% discount rate suggested by the tax authorities.

At the time of the transfer, the interest rate on long-term UK government bonds was approximately 2.5%. A 7% discount rate would be consistent with a 4.5% risk premium. If the equity risk premium were 5%, this 4.5% risk premium would be consistent with a Capital Asset Pricing Model (CAPM) beta coefficient. Aswath Damodaran provides estimates for beta coefficients by sector including the tobacco sector. Damodaran suggests that the equity beta = 1.22 with the equity to asset ratio = 0.7413. The asset beta would equal the equity beta times the equity to asset ratio, which would be approximately 0.9. As such, the assumption that the discount rate should be 7% is reasonable.

Paragraph 3.2.24 states:

"The projections in the 'Base Case' assume that profits will remain the same in the years 2016-2022. The defendant also assumed this. The Claimant believes this is not realistic. Projections are not the same as historical figures. The tobacco market in Western Europe is structurally shrinking. Moreover, it was foreseeable in 2016 that the tobacco market would be more strictly regulated. [Company 3] also could not benefit from the rise of alternative products, such as vaping, the plaintiff notes. In the aforementioned annexes II and III, it assumes a linear decline in sales of 6.7% per year and a 2% decline in profits per year, respectively. In contrast, the defendant argues that an internal presentation dated 15 April 2016 presents a scenario that assumes growth of 2%-2.5% per year for the group's Western European markets. Given the estimates in the 'Base Case' and the little evidence that the parties have mutually based their assertions regarding the future development of profit figures, the court sees no reason to assume movements in the cash flows to be taken into account."

The 20-F filings for British American Tobacco provide overall sales and operating profits as well as certain information with respect to regional sales and profitability. The earliest available 20-F filing was for fiscal year ended December 31, 2017, which was the first full year following the acquisition of Reynold America. Annual sales rose from £20.3 billion in 2017 to £27.3 billion in 2023 and averaged £25.3 billion per year over this 7 year period. Western European sales have been approximately 20% of worldwide sales. As such we shall assume that Western European sales = £5000 billion per year.

Transfer Pricing Issues

The court decision provided only snippets of the transfer pricing issues, but did not provide an overall financial analysis. The 20-F filings for British American Tobacco notes its operating margin exceeded 30%, which is typical for tobacco multinationals. The 20-F filing for fiscal year ended December 31, 2018 notes there were factories in 42 nations that partner with over 90 thousand farmers. Other affiliates are responsible for ongoing marketing, as well as ongoing R&D. Our illustration of tobacco transfer pricing will assume that the various costs of production and intangible development costs are borne either by the production affiliates or the British parent with the parent paying the production affiliates for their efforts. The transfer pricing issues will therefore focus on what the parent charges to the distribution network, which included a Dutch distribution hub for European operations before 2016 and a UK distribution hub from 2016 onwards.

For European operations, the following table assumes the following:

• Sales = £5 billion per year;
• Costs borne by the parent corporation and the production affiliates = 57.5% of sales; and
• Distribution costs = 12.5% of sales.

Overall operating profits therefore represent 30% of sales, which are allocated according to the transfer pricing policies.

Illustration of British American Tobacco Transfer Pricing Under Two Scenarios (in Millions)

The court decision noted the various aspects of the transfer pricing policies. The marketing hub paid the production affiliates the various costs incurred by these affiliates plus a 12% markup. The marketing hub also paid the owners of certain intangible assets various royalties for trademarks and for the use of innovation and technology. Our illustration combines these two intercompany payments as intercompany (I/C) price, which is set at 83.5% of sales for the original transfer pricing position. The marketing hub also affords the various distribution hubs for their operating costs plus a reasonable operating margin, which our illustration assumes represents 2.5% of sales. As such, the intercompany (I/C) price 1 that the marketing hub receives from the distribution hub is set at 85% of sales in our illustration. Under these assumptions, the marketing hub’s profits is given by the 1.5% difference between the intercompany price it receives from the distribution affiliates and the intercompany prices it pays to the other affiliates or £75 million per year.  The tax authorities successfully challenged the various intercompany prices paid to the affiliates that either provided production or intangible assets. Our illustration assumes that these adjustments lower I/C price 2 from 83.5% of sales to 82.5% of sales. This adjustment would increase the operating profits for the marketing hubs by £50 million per year.

One can reasonably question why a marketing hub with few employees or functions deserves any residual profits let alone residual profits as high as 2.5% of sales. Tobacco multinationals, however, are incredibly profitable enterprises. Reasonable estimates for the routine return for production and the routine return distribution would suggest that residual profits are very high. Note that our illustration would have the production affiliates and the affiliates receiving royalties capture profits = 25% of sales even under the tax authority’s position. How much of the residual profits for a tobacco company is attributable to marketing versus manufacturing intangibles has been a difficult and controversial issue for many years. My discussion of the role of transfer pricing for tobacco excise taxes considered this issue in terms of two U.S. domestic transfer pricing litigations where the taxpayer preferred most of the profits to be attributed to the marketing and distribution affiliate.

Takeaways

The value of an enterprise depends in part on the expected future profits of the entity. For affiliates of multinationals, the observed profitability depends on the transfer pricing policies of the multinational. The appropriate valuation of an affiliate should be based on the profits that would accrue under arm’s length pricing. The recent ruling by the North Holland District Court involving the transfer of certain distribution rights from British American Tobacco Exports B.V. to British American Tobacco UK Limited was based on a claim that the profits of this marketing hub were below what would have been observed under arm’s length pricing. Our review of the facts in this litigation noted that the initial profits may have been generous. As such, the tax authorities of the other affiliates could have argued that the transfer pricing charged to this Dutch affiliate should have been raised and not lowered. Had such a claim been successfully raised, the assigned £1.7 billion valuation may have been too high.

References

“Dutch Tax Authority Wins Challenge of British American Tobacco’s Intercompany Financing, November 10, 2022.

https://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/wacc.html 

“Tobacco Excise Taxes and Transfer Pricing”, Journal of Multistate Taxation and Incentives, October 2015.