Sibanda & Zantwijk

Nearly all intellectual property (IP) valuations prepared in South Africa for tax purposes use the relief from royalty methodology and “the 25% rule” for calculating the royalty. (See our proprietary Excel valuation model based on this rule)

According to “the 25% rule”, the royalty rate is generally expected to fall within the range 25% to 33% of profits before interest and tax (PBIT). However, this “rule” only applies where:

• the IP is a driver of sales/profits;
• the IP represents a relatively strong arsenal of assets;
• the IP grants the user protection from competition; and
• the IP appears to be valid and enforceable.

Consequently, the near ubiquitous application of this rule in IP valuations is surprising. What is even more surprising is the insistence by certain IP valuators’ to continue misapplying this “rule”, despite SARS’ current heightened vigilance and clear response thereto. This problem appears to be endemic, as appears from the following extract extract from “Fundamentals of Intellectual Property Valuation”, published by the American Bar Association at p35:

Misapplication of this “rule” benefits no one. It results in: IP being overvalued by a factor of more than 15; substantial losses to the fiscus; and the potential imposition by SARS of 200% penalties upon taxpayers (calculated on the inflated value). Furthermore, these valuators are largely responsible for the deep suspicion with which the public and regulatory authorities now view IP valuations, thereby indirectly affecting ethical valuators.

For instance, it is my opinion that this methodology is typically not applicable to the valuation of copyright or software, unless used in the business of software developers (such as Microsoft, Oracle, Adobe, etc). Generally speaking, the role of software is to increase efficiencies and reduce costs. As such, software should properly be regarded as a facilitator and not a driver of sales or profits. In this regard, also see Allowances for the acquisition of intellectual property and software.

Another common mistake that valuators make when applying this “rule” is to either ignore or improperly account for licences used by the proprietor of the IP. The effect of this omission/misapplication can be substantial.

For example, assuming that one wishes to value the trademarks used by a company with a turnover of R100m, that pays R4m in royalties and generates R24m in profits before royalties, interest and tax. The “Rule” is frequently misapplied as follows to justify a 5% royalty rate for the trademark:

Profits before royalties, interest and tax:       R24m

Royalties:                                                 (R4m)

PBIT:                                                       R20m

Reasonable royalty (using 25% of PBIT)         R5m

Trademark Royalty: 5% of turnover

In contrast, the proper manner for determining a reasonable royalty is as follows:

Profits before royalties, interest and tax:       R24m

Reasonable royalty rate (using 25% of PBIT): R6m

Royalties:                                                (R4m)

Reasonable royalty                                    R2m

Trademark Royalty: 2% of turnover

As is apparent from the above, by ignoring or improperly accounting for royalties payable by Opco, the trademark royalty could be overvalued by 150%! (Also see the article on Royalty Stacking)

The potential material effect caused by royalties payable must surely raise concerns when relying on benchmarking reports, where the effect of any royalties is wholly ignored.

It should also be borne in mind that SARS has developed new valuation models that automatically detects the above “errors”. In addition, SARS’ models compare the discount rate, growth rates, royalty rates and useful economic life used in IP valuations against other objective factors (including a cap on earnings attributable to intangibles) for reasonableness and will challenge these valuations where any of these factors fall outside their parameters.

In closing, a word of caution: do not accept unquestioningly misleading and irresponsible statements that valuations are subjective and difficult to challenge in court - SARS has both the tools to challenge these valuations objectively and the appetite to obtain judicial precedents.

  Anthony van Zantwijk (January 2007) 

Sibanda & Zantwijk

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