What You Should Know About the Discount Rate in A Transfer Pricing Valuation

The discount rate is one of the most important variables to consider when preparing a transfer pricing valuation. The OECD Transfer Pricing Guidelines define the discount rate as follows:

The discount rate or rates used in converting a stream of projected cash flows into a present value is a critical element of a valuation model. The discount rate takes into account the time value of money and the risk or uncertainty of the anticipated cash flows.[1]

Valuation results are often very sensitive to the discount rate. A small variation in the selected discount rate can lead to large differences in value, especially in situations where the valued asset is expected to generate cash flows over a long period. For this reason, transfer pricing disputes may involve taxpayers or tax authorities devoting significant resources to support their argumentation on the discount rate.

Transfer Pricing Guidance on The Discount Rate

One example in which the tax courts took interest in the discount rate is a ruling from 11 July 2024, (ECLI:NL:GHAMS:2024:1928), where the Amsterdam Appellate Court addressed a tax dispute concerning the restructuring of the Dutch business of a foreign multinational enterprise. Part of the dispute addressed the discount rate that should apply to the valuation of a tolling business. The taxpayer argued that the toller’s cash flows required a lower discount rate relative to the weighted average cost of capital (WACC) of fully entrepreneurial industry peers. However, an expert report prepared on behalf of the Dutch Tax Authorities did not find reasons why the toller’s WACC should differ from the industry.

More generally, the OECD Transfer Pricing Guidelines expect the discount rate to be determined with regard to the risks associated with the specific cash flows in question but acknowledge that there is no single measure that would be appropriate for transfer pricing purposes in all instances. The Dutch Transfer Pricing Decree of 2022 acknowledges the WACC as possible base upon which to determine the discount rate but also sees as relevant the risk profile of the parties involved and the characteristics of the valued asset.[2]

Broader valuation principles outside of transfer pricing are also consistent with the idea that riskier assets or cash flows merit a higher discount rate. One example in valuation practice is the weighted average return on assets (WARA) approach, which decomposes a business into its constituent assets such as cash, working capital, tangible assets and intellectual property (IP), among others. The average return across all assets is expected to equal the WACC but some assets, e.g., cash, clearly have lower returns than the WACC. By implication, other assets, e.g., the IP must have expected returns that exceed the WACC. The WARA approach attempts to quantify these differences and arrive at a specific discount rate applicable to the IP.

The CAPM Approach to The WACC In Transfer Pricing

The WACC itself is frequently based on the Capital Asset Pricing Model (CAPM), used commonly in valuations for other purposes too. The WACC is calculated by weighing the estimated cost of equity and cost of debt by their respective proportions in the “normal” capital structure of the business.

The CAPM estimates the cost of equity component of the WACC based on a certain risk-free rate and a premium that compensates investors for the risk associated with the investment in the business. The risk premium in turn is derived from the overall market risk premium and a “beta” factor that measures the volatility of the specific investment relative to the overall market return. The CAPM only compensates investors for “systematic” risk which cannot be diversified away; idiosyncratic risks associated with specific investments are not factored into the cost of equity. Those other risks, such as the risks associated with a small firm or private ownership, are often added later on. In summary, calculating the estimated cost of equity requires many assumptions.

The cost of debt is generally more easily observable than the cost of equity. For the cost of debt, the borrowing cost of the MNE itself or the borrowing terms available to industry peers are usually considered. 

Common Transfer Pricing Questions on the Discount Rate

From a transfer pricing perspective, there are at least several questions to consider when using the CAPM:

• What are the right peer companies to use when setting the “beta” parameter? Normally, valuation practice references peers / comparable companies from the industry. However, transfer pricing valuations frequently focus on entities that may have a different functional profile from the typical industry peer, e.g., a limited risk distributor in an industry where publicly traded companies are mostly manufacturers.
• How should the weights of the debt and equity components in the WACC be determined? General valuation practice tends to use the industry averages, but some tax court cases addressing transfer pricing valuations have suggested that the specific WACC of the MNE parent is more relevant than an industry average.
• Are additional “risk premia” on top of the CAPM appropriate? Valuation practitioners frequently use small firm size and company specific premia. While theoretically these premia are inconsistent with remunerating only “systematic risk”, empirical evidence over time has shown the CAPM underpredicts the investment returns of smaller firms. Some debate still remains  among academic finance researchers on this topic. Given the high technicality of this area, tax authorities are likely to approach additional risk premia with some degree of skepticism. Taxpayers should take extra care into documenting the appropriateness of any premia applied and/or showing that such premia are commonly acceptable in their industry.

Additional Discount Rate Considerations

Taxpayers should avoid formulating the discount rate in isolation from the regional/local market characteristics and the financial projections expected to be used for the valuation. If the risk-free rate embedded in the WACC is 4%, the inflation assumption underlying the financial forecasts should make sense in a world defined by 4% risk-free rates. Other reasonableness checks may also be considered. For example, the cost of equity would normally be at least as high as the cost of debt, given that debt investors have a priority claim on the company’s assets. If the taxpayers’ cost of debt exceeds the cost of equity derived using the CAPM approach, the assumptions should be revisited.

In conclusion, setting an appropriate discount rate for a transfer pricing valuation is a highly technical exercise that has to take into consideration multiple factors. If you would like to know more, please reach out to KPMG’s tax valuation specialists.
 

[1] OECD (2022), OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations 2022, OECD Publishing, Paris, https://doi.org/10.1787/0e655865-en. See Par 6.170.

[2]Decree of 14 June 2022 no. 2022-0000139020, Staatscourant 2022, no. 16685.