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Valuation Insights: Fair Market Value
Method of Allocating Interest Expense
This article was written by Timothy Ramsayer, Senior Managing Director of American Appraisal.
Overview
To calculate taxable US income, the Internal Revenue Code (IRC or the Code) includes numerous
provisions for how expenses and deductions should be measured against income. For multinational
companies, this calculation is complicated by the need to follow specific guidance to determine income
and expenses generated from within and outside the United States.
The guidance for such calculations (or interpretation of the Code) is set apart from the actual Code
and published in the Treasury Department Regulations (Regulations). The Regulations are complex and
exist in temporary, proposed and final forms. All three forms of the Regulations are valid guidance for
taxpayers, and temporary regulations can remain in that state for years. In addition to the Regulations,
other advisory documents, revenue rulings, revenue procedures and/or tax rulings exist to provide
further guidance on particular sections of the Code.
Under the §861Treasury Regulations, taxpayer guidance is provided for various deductions including
costs related to research and experimental activities, accounting and legal fees, charitable contributions
and interest expenses, among others.
While gross income is used as the basis for allocating and apportioning most deductions under §861,
interest expense is unique in that under IRC §864(e)(2), interest expense is apportioned based on asset
values, hence creating the potential need for valuation assistance.
Guidance for allocating interest expense under IRC §163 is provided under Temporary Treasury
Regulations §861-9T, and only interest deductible under IRC §163 is normally subject to this asset
value method under §861-9T.
For allocating deductible interest expense under IRC §163, taxpayers can select from three alternative
methods: tax book, described under §861-9T(g); alternative tax book, described under §861-9T(e); and
fair market value, described under §861-9T(h). By default, taxpayers use the tax book method, but they
may elect to use the alternative tax book method (introduced in 2004) or the fair market value method,
which may prove to be most advantageous for a taxpayer.
A few notable valuation points about using the fair market value method include:
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The requirement to allocate and apportion interest expense following the Regulations applies
to most all US taxpayers. Therefore, the Regulations generally apply to public and private US
companies, as well as foreign corporations reporting US income.
•
Similar to the alternative tax book method, electing to use the fair market value method does not
require the consent of the IRS; however, it should normally be selected with a long-term plan in
place. Subsequent decisions to use another method may require the consent of the IRS and/or the
need to follow specific transition guidelines.
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While exceptions exist, all three methods normally apportion interest expense to the various statutory groupings (not
discussed herein) based on yearly averaging of asset values within such groupings, using beginning- and end-of-year data
points. In the first year, a year-end data point may normally be used without a beginning-of-year data point.
•
When the fair market value method is elected, the taxpayer is expected to establish the value of its assets to the satisfaction
of the IRS. If a taxpayer fails to establish the fair market value of an asset or group of assets to the satisfaction of the IRS, the
IRS can establish the appropriate value of the asset or group. If the taxpayer fails to establish an appropriate fair market value
basis for a substantial portion of its assets, the IRS may force the taxpayer back onto the tax book value method.
•
Generally, an election to use the fair market value method can be made retroactively to all open tax years.
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§861-9T(h)(1)(ii) of the Regulations provides the overall guidance for valuing tangible assets. The actual guidance is limited,
but expresses an expectation that generally accepted valuation techniques are followed and allow for assets to be combined
into reasonable groupings for analysis. The Regulations also afford the use of statistical measures to value fungible property.
The traditional profile for companies using the fair market value method included long-established US manufacturers, with
significant amounts of older but very operative property, plant and equipment, that more recently expanded outside the United
States through organic growth or acquisition. The attraction for taxpayers with this profile is the expectation that the older, more
fully depreciated US assets will recognize a greater positive change in value (tax book to fair market value) than their foreign assets
that are newer, have recently been acquired or are being straight-line depreciated.
Today this profile is still relevant, but the profile of companies using the fair market value method has broadened. For some
businesses, even a modest change in asset values or in the domestic-to-foreign asset mix provides incentive to make the election.
2012 Temporary Regulations Update
In early 2012, new temporary (T.D. 9571) and proposed (REG-113803-10) Regulations were released related to the allocation
and apportionment of interest expense. In addition to addressing the interest allocations by partners, and amendments to the
Regulations related to affiliated groups, these important Regulations provided new guidance to the fair market value method.
Specifically, the revised temporary Regulations amended certain elements of the multistep process that taxpayers must follow
to establish the fair market value of their assets, especially those elements associated with certain related-party stock and debt
matters.
The following is a summary of the multistep process that was introduced, also referred to as the six-step process:
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Step 1: The taxpayer determines the aggregate value of assets that it and its subsidiaries own (consolidated group). For a
public company, this would equal the aggregate trading value of the stock at year-end, increased for liabilities to unrelated
parties and its pro rata share of liabilities of all related parties owed to unrelated parties.
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Step 2: The taxpayer establishes the fair market values of its tangible assets and its pro rata share of assets held by related
persons, excluding any stock or indebtedness in a related person.
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Step 3: The taxpayer subtracts the amount determined in Step 2 from the amount determined in Step 1 to arrive at total
intangible asset value.
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Step 4: Apportion the intangible assets owned by the taxpayer among the taxpayer’s affiliates under §1.861-9T(h)(2) on the
basis of net income.
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Step 5: Once the taxpayer has determined the fair market value of its intangible assets, those assets must be characterized
as provided in §1.861-9T(h)(3).
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Step 6: The rules of §1.861-9T(h)(4) apply to determine the value of stock in a related person held by the taxpayer (or by
another person related to the taxpayer). Under those rules, §1.861-9T(h)(4) states that the value
of such stock is equal to the sum of the following amounts, less the taxpayer’s pro rata share of
liabilities of such related person: (i) the intangible assets apportioned to the related person in Step 4,
above; (ii) the tangible assets (as determined in Step 2) held by the related person; and (iii) the total
value of stock held in all other related persons held by the related person.
As excerpted from T.D. 9571, the key element of change in the revised temporary regulations is:
The IRS and the Treasury Department have become aware that certain taxpayers are
taking the position that the language of Step 2 of the FMV method, which requires
related party debt to be excluded as an asset as part of the process for determining
total intangible asset value, means that such debt also is not treated as an asset in the
hands of the taxpayer for the broader purpose of applying the asset method. In addition,
for purposes of valuing the stock in related persons under Step 6, some taxpayers are
taking the position that those rules exclude related party debt as an asset (because of
the reference in §1.861- 9T(h)(4) to §1.861-9T(h)(1)(ii)), but permit reduction of the value
of the stock of the related person obligor by the amount of the related party debt as
a liability (because the language of §1.861-9T(h)(4)(ii) does not limit the reduction for
liabilities to unrelated party liabilities).
The IRS and the Treasury Department believe that interpreting the regulations to require
that the related party debt be taken into account as a liability for purposes of valuing
stock in the related person without also treating the related party debt as an asset in
the creditor’s hands distorts the relative values of assets assigned to each statutory
grouping. This result is contrary to the general principles of the §1.861-9 regulations,
which are based on the concept that interest expense must be apportioned on the basis
of the value of all assets. Accordingly, these temporary regulations amend §1.861-9T(h)
(4) to reflect the fact that related party debt is an asset that must be taken into account
whether held by the taxpayer or a related person.
These temporary regulations first revise §1.861-9T(h)(4) by adding a new paragraph
§1.861-9T(h)(4)(i) to provide for the valuation of related party debt. Prior to its revision by
these temporary regulations, §1.861-9T(h)(4) provided for the valuation of the stock of
a related person, but the regulations did not provide any explanation of how the related
party debt is to be valued. As revised by these temporary regulations, §1.861-9T(h)(4)
(i) provides that a related party debt obligation held by a taxpayer or another person
related to the taxpayer has a value equal to the amount of the liability of the obligor
related person. These temporary regulations also revise §1.861-9T(h)(4) by providing that
the value of stock in a related person includes the taxpayer’s pro rata share of related
party debt held by the related person. Finally, these temporary regulations provide a new
example illustrating the changes made to §1.861-9T(h)(4).
These amendments make clear that related party debt is an asset in the hands of the
creditor for purposes of applying the asset method and is included in the valuation of
stock of a related person. Very broadly, these changes ensure that both the receivable
and the payable sides of related party debt are included for valuation purposes under the
FMV method, and that the value of each side is determined in a consistent manner. No
inference is intended regarding the interpretation of prior regulations as a result of these
modifications.
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Considerations
The fair market value method has existed for more than 20 years, so fewer taxpayers are making a first-time election. However,
companies that make acquisitions that change their domestic and foreign tangible asset profile could have reason to investigate
the potential benefit, as could taxpayers that now have foreign tax credits.
In addition to tax advice, it is advisable for taxpayers exploring the fair market value method to retain an experienced valuation
advisor early in the due diligence process. An experienced valuation advisor with global capabilities:
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Can assist with sensitizing potential value changes that might occur between the domestic and foreign asset groupings by
moving from tax book value to fair market value
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Will be able to provide appropriate scope-of-work guidance and ideas for valuing all of the tangible assets in a manner
adhering to IRS guidance
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Will be able to work with the taxpayer to decide if a turnkey solution is suitable or to what degree the taxpayer’s internal
resources could be leveraged to develop or maintain the valuation analyses
Although these Regulations have existed for two decades, awareness of the valuation aspects that support the calculations to
apportion interest expense is always important. Whether a taxpayer is investigating a first-time election, experiencing discomfort
with the current state of the valuation support, or simply not satisfied with the current valuation process, experienced valuation
advisors can provide guidance through the valuation complexities of the fair market value method.
The information contained herein is of a general nature, noncomprehensive and not intended to address the circumstances of any particular
individual or entity.
About American Appraisal:
American Appraisal, the world’s only glocal valuation firm™, is a leading valuation and related advisory
services firm that provides expertise in all classifications of tangible and intangible assets. The Firm
comprises 900 employees operating from major financial cities throughout Asia-Pacific, Europe, the Middle
East, and North and South America. Our portfolio of services focuses on four key competencies: Valuation,
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