PENSION SCHEME DEFICITS: CAN INTELLECTUAL PROPERTY RIGHTS HELP?

Intellectual property valuation expert Stuart Whitwell and IP solicitor Serena Tierney explain how IP such as brands, patents, copyright and contracts, as well as tangible assets such as property and shares, can be valued and used to fill pension scheme deficits.

Company pension deficits are near an all time high. According to the Pension Capital Strategies report, November 2010, in the UK, the FTSE 100’s combined deficit is estimated to have hit £66 billion as at September 2010. Even the pharmaceutical sector is not immune and some major companies have significant deficits. Reducing these deficits is now a major issue at boardroom level.

Scheme trustees will push for fully funded schemes as soon as possible, but company directors need to use their capital for the company's operations and to get through the investment phase of each product’s life cycle and come out at the other end in good shape. Even if there is no final salary trustee breathing down the necks of the directors in that situation, there can be other powerful incentives to put a valuable asset into a company pension scheme:

• Future-proofing capital gains tax liabilities.
• Protection from insolvency risk. Pension schemes usually do not fall into the hands of a company’s bankers or liquidators if the company fails.
• Corporation tax relief possibly using carried forward losses.

One option is to use non-cash tangible assets, such as property, to fund the scheme. The company transfers the asset to a special purpose vehicle and then leases the asset back. The pension scheme has an interest in the same vehicle, which gives it a right to the future rental payments. The discounted net present value of those future payments is an asset of the pension scheme and the deficit is reduced by the value of the asset. Usually, there is a mechanism that provides that, in event of default, ownership and, therefore, the value of the asset(s) is transferred to the trustees.

Increasingly, for many companies the majority of their assets are intangibles — most particularly intellectual property (IP). So the question arises of whether there is scope to use IP assets in a similar manner. In practice, most of the same considerations apply to IP assets as to tangible assets used in the day to day business of the company. So, if a company has valuable intellectual property rights (IPR) how could it (and when should it) consider putting those rights into a pension scheme?

As with all things pensions-related, this is a heavily regulated area. To prevent a pension scheme being subject to Enron style “double jeopardy” when a company becomes insolvent, there are strict rules about the extent to which UK pension schemes can hold assets (such as IPR) that are used in the business of the sponsoring employer. The idea is that, if the company goes bust, the pension scheme should not be heavily exposed to that failure.

In very broad summary, most pension schemes can only hold up to 5% of their assets in “employer related investments” (ERIs); and ERIs would include things such as shares issued by the company, property occupied by it and assets including IPR used in the company’s business.

To avoid the 5% restriction applicable to most schemes, it is possible to structure investments of this kind through a special purpose vehicle (SPV), such as a Scottish limited partnership (LP) or a Dutch Stichting. These SPV structures do work and have been used for this purpose by companies such as Marks & Spencer and GKN. They are still new, but are becoming less exotic every month. There are some specific legal issues that arise when transferring IP in this manner and they are discussed below.

Benefits
There are many benefits of such a solution both to the employer company and to the pension scheme trustees.

To the company
It is currently unusual for a company to recognize the value of its IP on its balance sheet unless it has been acquired. Internally generated IP may be the company’s most significant asset, but its value may only be reflected in the general estimate of the value of goodwill. The value inherent in a company’s IP, therefore, may be either guessed at or ignored and it may well represent an underused capital asset.

Using IP to reduce pension deficits is an effective way of using the capital value of that asset and of communicating its value to shareholders. A key benefit can be the immediate reduction in the company’s pension deficit, which in itself can be a significant burden on the company’s performance. This reduced deficit lowers the scheme’s Pension Protection Fund (PPF) levy payments, which the sponsoring company usually pays. Transferring IP to the scheme in lieu of cash lowers annual contributions as deficit payments are spread over a longer period, thereby improving cash flow. Enhanced cash flow provides increased funding for the company’s business operations with consequent financial benefits. It can have a beneficial effect on the share price as what was previously a significant liability is now being managed more effectively.

Another key benefit is that there is an acceleration of corporation tax relief as future pension contributions are paid in one lump sum. This can be a considerable gain making the scheme immensely attractive.

For some pension schemes, there may be an argument that their deficits are currently artificially high. Contributing assets through the SPV mechanism can be structured to allow for the income stream to be returned to the company in the future if the current level of contributions is no longer required to fund the scheme. This mitigates the risk that, if asset values return to something approaching previous levels, schemes might be over funded with too much cash having been contributed, which cannot then be retrieved for the company.

To the trustees
Pension scheme members and trustees benefit from the immediate reduction in the scheme’s deficit. The key benefit is the improved security position that the trustees have as a creditor of the sponsor. Whereas previously they might have been an unsecured creditor, this structure often gives trustees control of an asset they can sell if the company fails to meet its obligations. This, of course, is enhanced further if the asset increases in value. It is also a major benefit for the trustees, even if one not readily accounted for in cash terms, for the employer company to have more free cash to support its day to day operations.

Mechanics
All very well in theory. But, in practice, how does one go about selecting and valuing the IPR that would be used in setting up one of these advantageous structures? First, the IP must be separately identified. It may be a brand, technology or ‘content’ — typically audio visual or musical works. It can make sense to use a brand alone; for example, where the company’s name or brand is — or is one of — its major trading assets. Similarly, a specific piece of technology such as magnetic resonance imaging may be distinct from the rest of the company’s business. Often, though, it will be a product stream — such as a drug — where the bundle of IP rights that protect that income stream include not only the patent and supplementary protection certificate rights protecting the formulation itself, but the associated bundle of trade mark and trade dress rights that together drive the commercial revenue. The key consideration is to have an identifiable capital asset (or bundle of assets) and an associated revenue stream.

Next, the IP must be valued. For some time now well established valuation methodologies have existed, both for brands — which are now enshrined in the ISO brand valuation standard — and for patents. There are an increasing number of experienced specialists in valuing IP for various types of corporate transaction whose valuations have proved to be robust when tested in a range of situations including by the courts and by tax authorities. Provided that the methodology used is one of the usual ones and its application is transparent (required for compliance with the ISO standard), pension scheme trustees may have confidence in it when reaching their investment decisions.

An analysis of the potential for triggering an exit charge for capital gains tax purposes is also needed. It is usually possible, particularly in circumstances where the purpose of the transfer is to benefit the employer company’s pension scheme, to avoid triggering such a liability, but care must be taken in establishing the structure.

The IP will then be transferred to the SPV to be used. Different structures will reflect differing corporate considerations, but at its most basic, this will be to the vehicle in which the pension scheme trustees will invest. As the transferring company will need to use the IP rights in its business, it will take licences of those rights and pay in return a royalty. This provides the income stream that is fed through to provide the cash flows to the trustees, upon which they base the value of their interest in the SPV. The licences-back must be at an arm’s length value and these transactions often provide a useful opportunity for groups of companies to ensure that their licensing practice complies with the requirements of the transfer pricing tax regime.

As mentioned above, special considerations do apply to the use of brands or trademarks in this way. As a matter of trademark law, only the registered owner exercises control of the use of the trademark. This requirement may be met in many ways, but if the transfer is taking place to (or via) a jurisdiction with an advantageous tax regime, it may be necessary to transfer those of the company’s personnel responsible for managing the brand to become tax resident in the same jurisdiction. This extreme step is usually unnecessary because most SPVs are established through a Scottish LP.

The trustees are under an obligation to monitor the value of the assets of the scheme on an ongoing basis. Depending on the ‘headroom’ between the value of the trustees’ interest in the SPV and the value of the underlying IPR, it might be necessary to put in place policies to measure the impact on the value of the IP of the company’s regular trading activities, as well as any relevant external events occurring after the transfer.

Finally, as with all corporate assets, it will be necessary that it is not subject to any prior restrictions on its use in this manner. If it is, then those restrictions will need to be removed before the transaction can proceed. Typically with IP assets, the problem tends to be a floating charge over all the company’s undertaking and assets. As the IP has not usually been accorded a specific value, but has been included without either party giving any thought to the value concerned, frequently no real difficulty arises in freeing it from that charge.

Conclusion
Use of a company’s IP rights may be an opportunity to put to work a capital asset that is currently undervalued (or even unvalued) on its balance sheet and which can relieve the company of the need to make cash contributions to fund its pension scheme deficit. It is now well established that the legal and regulatory obstacles are surmountable, safely and properly; and the financial, asset protection, tax and accounting benefits of doing so can be considerable.

Recent examples of use of IP or other rights to reduce deficits

IP

• Diageo -  £500 million worth of maturing whisky stocks (July 2010)
• GKN  - assets including its trade mark valued in total at £331 million (March 2010)
• Interserve - 13 public finance investment (PFI) contracts worth £61.5 million (2009)

Shares

• ITV - shares in its digital channel operator, SDN. (May 2010)
• John Lewis - 29% share holding in online retailer Ocado (January 2010)

Real property

• Sainsbury - £750 million of property (May 2010)
• Marks and Spencer - property totalling £1.1 billion. (Three tranches in 2007, 2008 and 2010)
• John Lewis - £150 million of property. (January 2010)
• Whitbread - property worth £228 million. (May 2010)