Valuation of Software: CA Software Israel Ltd

The Israel Tax Authority prevailed in Israel vs CA Software Israel Ltd (October 2022, Tel Aviv District Court, Case No 61226-06-17), which involved the valuation of transferred software. Memco Software was founded in 1990 in Israel. Platinum Technology acquired Memco Software for $400 million during September 1998. Computer Associates (CA) purchased Technology during March 1999. Memco Software was renamed CA Software Israel Ltd. Late in 2010, the software intangibles of this Israeli affiliate were transferred to another CA affiliate for 111.3 million new Israeli shekels (NIS), which was just under $31 million given that one dollar at the time would exchange for 3.6 NIS. The Israel Tax Authority asserted that the fair market value of these transferred intangibles was 667 NIS or $185 million.

The representatives of the taxpayer and the tax authority sought the testimony of various expert witnesses on what would be a reasonable application of the discounted cash flow (DCF) approach. The taxpayer’s experts tried to justify the lower valuation arguing that the economic useful life of the transferred intangibles was very short. The tax court noted the contrasting positions on the economic useful life issue thusly:

What is the expected growth rate for IP in general, and for intellectual property software - is it positive according to the opinion of the respondent, or negative according to the opinion of the appellant. In other words, while the appellant treats the intellectual property for its future benefits as dead business - intellectual property whose time has passed and its value fades, the respondent treats the intellectual property as a living business - a yielding asset with the potential for continued profit.

The tax court also contrasted the valuation estimates of both sides with the 1998 acquisition price:

Another indication can also be found in the average income of the appellant moving to the seller. As the company has an operating profit of about NIS 70,000,000 on average each year, it is reasonable to assume that its activity will not be sold for a little over NIS 100,000,000 … Accordingly, the appellant was bought at the time for approximately $400,000,000, so that the valuation of the company was around $185,000,000 - It sounds reasonable.

The U.S. transfer pricing regulations describe various approaches for evaluating the market value of intangible assets under section 1.482-7 including the acquisition price method:

Adjusted acquisition price. The adjusted acquisition price is the acquisition price of the target increased by the value of the target's liabilities on the date of the acquisition, other than liabilities not assumed in the case of an asset purchase, and decreased by the value of the target's tangible property on that date and by the value on that date of any other resources, capabilities, and rights not covered by a PCT or group of PCTs.

Section 1.482-7 provides the following warnings with respect to the use of this method:

the reliability of applying the acquisition price method as a measure of the arm's length charge for the PCT Payment normally is reduced if:

•  A substantial portionof the target's nonroutine contributions to the PCT Payee's business    activities is not required to be covered by a PCT or group of PCTs, and that portion of the nonroutine contributions cannot reliably be valued;

•  A substantial portionof the target's assets consists of tangible property that cannot reliably be valued; or

•  The date on which the target is acquiredand the date of the PCT are not contemporaneous.

Even if the transfer of the software occurred in late 1998, the use of the acquisition method might be suspect as Memco Software had developed four types of software for information security with three of them becoming negligible in value. The issue in this litigation was the value of SeOS software. The fact that the transfer occurred twelve years later further brings into question the reliability of any application of the acquisition approach. While the expert witnesses for the taxpayer asserted that the value of this software over time had declined, the experts for the Israeli tax authority asserts that the remaining software business had flourished and had a bright future.

The value estimate provided by the taxpayer’s experts was less than 8% of the original purchase price, while the value estimate provided by the experts for the Israel tax authority was over 46% of the original purchase price. Each set of experts relied on applications of the DCF approach. We shall speculate on how the tax authority’s expert witnesses applied this approach and provide a possibly critique.

Discounted Cash Flow Approach

A November 2022 EdgarStat Blog post on the application of the DCF approach critiqued the approach of the expert for the French Tax Authority noted in the October 27, 2022 decision by the French Conseil d’Etat in Sacla SA v. Ministre de l'économie, which involved the transfer of certain brands from Coverguard to its Luxembourg affiliate.  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. Our discussion of the Memco Software litigation will follow the approach we used in our discussion of the Coverguard brand issue:

Our discussion presents a steady state version of DCF to explore how these key assumptions may lead to what the tax authority originally asserted as well as lower plausible valuations … A simple version of DCF would estimate the value (V) of a brand as:

V = Ct/(r – g),

where Ct = the cash flows from the brand, g = the steady state growth rate of these cash flows, and r = a reasonable discount rate. Some valuations are based on the questionable premise that cash flows represent the royalties from the use of the brands, which ignores ongoing marketing expenses required to maintain the brand value.

For the Memco software case, let’s assume initial sales = $60 million per year with expected sales growth (g) being 3%. Let’s also assume that the discount rate (r) = 15%, which would imply that the value of the software represents 8.33 times initial cash flows. The following table shows the derivation of cash flows and the implied value using different assumptions with respect to what a reasonable royalty rate would be as well as the assumption with respect to ongoing intangible development costs (IDC).

Table 1: Valuation Under Alternative Assumptions

Translating sales into cash flows requires two fundamental assumptions. The first is what would represent a reasonable royalty rate under arm’s length pricing. The actual transfer pricing policy afforded the operating affiliates that were responsible for marketing and distribution 65% of sales leaving the owner of the software with a royalty equal to 35% of sales. Our table reflects this division of revenue as an intercompany payment to the operating affiliates equal to $39 million per year with the software intangible owner receiving $21 million per year. Software multinationals often compensate their sales affiliates with a gross margin that covers their operating expenses relative to sales plus a reasonable operating margin. While the court decision did not specify how this 65% gross margin for the sales affiliates was justified, the Israel Tax Authority did not challenge whether this intercompany policy was arm’s length.

While our table maintains this division of revenue for each of the scenarios presented, we have assumed different levels of intangible development costs (IDC) relative to sales. The first column essentially ignores any ongoing intangible developments costs. In this case cash flows = royalties, which implies that the value of intangible assets would be $175 million. If the expert witnesses for the Israel tax authority relied on a DCF approach that ignored the role of intangible development costs, this value estimate would overstate fair market value. As we noted in our prior post on the use of DCF models:

Infinite-life approaches implicitly assume that an asset will continue to have value indefinitely if reinvestment in such occurs. Such an approach requires defining cash flows as net profits, which equals royalties minus ongoing intangible development costs. Applying an infinite useful life to projections where the owner does not reinvest would overstate the asset value. Such a valuation would provide no place for the costs of investing or the declining profits over time from not investing. Valuation approaches that rely on short economic lives but also deduct ongoing intangible development costs would, on the other hand, underestimate value by double counting the entity’s investment and the loss of value from lack of investment.

Our table considers different levels of IDC relative to sales. If this ratio were a mere 5%, then cash flows would represent 30% of sales or $18 million for the initial year. If this ratio were 15%, then cash flows would represent 20% of sales or $12 million for the initial year.

Takeaways

The Israel tax authority relied on an application of the DCF to value the Memco software intangibles transferred in late 2010 that assumed an infinite useful life. Such an approach requires the analysis to not only specify what a reasonable royalty rate should be, but also that the ongoing intangible development costs are factored into the specification of cash flows. If ongoing intangible development costs are not deducted from arm’s length royalties, then this type of DCF approach would overstate the fair market value of the software intangibles.

References

Harold McClure, "Valuing Brands Using a Discounted Cash Flow Approach," EdgarStat Blog, November 25, 2022.