Alchemy ‐ converting the nature of an asset in a sale of business

A business is typically valued by discounting future earnings. Instead of acquiring the shares in the business, it is often more tax advantageous to acquire the business through a sale of assets. However, after attributing value to tangible assets (e.g. furniture, plant, vehicles, etc.) ‐ which are typically valued at their tax value to sidestep potential recoupment ‐ a substantial portion of the purchase price remains outstanding. Unless the business uses patents, designs or copyright (i.e. assets that qualify for allowances in terms of s11(gC)) in the production of its income, the balance must be attributed to "goodwill". This news is seldom welcomed with a smile as acquired goodwill is not deductible in the hands of the buyer. In some instances, parties resort to the following transaction to improve the tax efficiency of the sale:

  1. The information of the business (e.g. database information, recipes, client lists, equipment tolerance / settings information, etc.) is downloaded onto a CD. The intention being to convert what is otherwise merely know‐how and confidential information into "software" (which it is not).
  2. The "software" is then valued. However, since the tangible CD has little value, the parties recognise that "software" embodies "copyright". Now that the know‐how has been converted into software and the software converted into "copyright", the "copyright" is valued using "the most common valuation methodology to value IP" … "the 25% Rule", which discounts between 20% and 33% of the profits before interest and tax of the business, forecast for the useful economic life of the copyright (say 5 to 10 years), using the weighted average cost of capital as the discount rate. Despite that: (a) this valuation approach seldom finds any application when valuing copyright in software (as confirmed by the American Bar Association); and (b) the inputs are inapplicable and easily challenged, the parties rely on this valuation methodology to grossly exaggerated the value of the "copyright" such that no goodwill of any value remains in the business ‐ the ultimate goal of the exercise.
  3. However, this "copyright" does not retain its nature for long, as the sale of copyright to a purchaser for use within its business is deductible over 20 years, if at all. As such, this intangible asset (copyright) converts back into tangible software, and the sale agreement provides for the sale of "software" at a highly inflated value, which "software" is then written off by the buyer over 2‐3 years in terms of s11(e).

To summarise, information is converted into tangible software, which is converted into intangible copyright, which is valued using an incorrect methodology, which is converted back into tangible software such that much of the value of the goodwill in the seller is incorporated into the value of the information ‐ apologies, "software" (got a little confused)

In our opinion such transactions are fraudulent.

(Updated 2007)

Articles: Taxation