IP valuation: importance of being earnest

How often has your reaction to an IP valuation been "Wow, that's high!" Then it is not surprising that this is also SARS' standard reaction to IP valuations.

Where IP valuations are prepared as part of a tax or structured finance transaction, it is essential for the IP valuation to pass close scrutiny. It is not sufficient merely to adopt "common methodologies", "rules of thumb" and "benchmarked royalty rates", as too many transactions have been unwound, mainly due to the resultant excessive valuations. Our Courts have consistently held that a purchase price that is not genuine severely undermines the nature of a sale. In this regard, see Gardiner JP's comments in Anderson v Kaplan 1931 CPD 50 at p52:

"Now in the first place it is significant that the agreement of sale fixes the purchase price at the exact sum which Ormond owed Kaplan. It has been laid down that one of the tests as to whether a sale is genuine or not is whether there has been a true and fair price. The price is arrived at in this case without any consideration as to the value of the goods."

Structured finance transactions also frequently require the sale of the bare dominium in the IP (i.e. ownership less the right to use for a period of time). In the past, a nominal value was typically ascribed to this asset. Generally this value was not supported in any way. It is doubtful whether bare dominiums can continue to be valued in this reckless manner. Australian law, for instance, scrutinizes residual values. In this regard, TR 95/30 (Australian tax ruling) at par.12 states:

"If a sale price for the asset at the end of the lease is set at the time the lease is entered into, it may not reflect the actual market value at the end of the lease. Therefore the lease payments may have a capital component. However, the Commissioner will accept an up front valuation of the expected market value of the asset at the end of the lease in the case of long term leases (e.g., greater than four years), provided such valuation is made bona fide, and based on independent evidence or set in accordance with Taxation IT 28 and Taxation Determination TD93/142."

Accordingly, any discount in the bare dominium value could result in related rental or royalty deductions being apportioned and partly denied on the basis that a portion represents expenditure of a capital nature.

One should therefore steer clear from applying a valuation methodology merely because it is common. If the methodology cannot be justified in Court, the valuation is useless. In South Africa, nearly all IP valuations performed for tax purposes apply the discounted cash flow (DCF) model in combination with the "25% Rule" (for determining a "reasonable royalty") ‐ otherwise known as the Relief from Royalty Methodology. However, the 25% Rule is only appropriate where the IP:

(a) represents a strong arsenal of assets;
(b) is shown to be valid and enforceable;
(c) is a driver of sales or profits; and
(d) grants the holder protection against competition.

So why the near ubiquitous application of this method? Simple, it generally yields the highest value … by far. And, everyone knows this.

Although a well known trademark may in certain instances satisfy these requirements, many other classes of IP should find it extremely difficult to squeeze into this model. Of particular concern is the valuation of copyright in software using the DCF model. Due to the nature of copyright, the owner typically holds a weak arsenal of assets that is easily circumvented and provides only ancillary support to the business (i.e. reduces costs or increases efficiencies). Seldom can it be proved that the software protects the holder against competition or that it directly drives sales or profits. This is not only my opinion, but also that of the American Bar Association:

"A note of caution: Although the relief‐from‐royalty method has been in use for many years, in the last decade it has become misused and abused to a great extent. Too many valuations are based on these theoretical "marketplace royalty rates" to calculate value … For the most part, the cost approach might be an appropriate method to use when valuing technologies in the earliest stages of development, or when equivalent functional, non‐infringing alternatives may be easily designed (e.g. software) because it reflects the cost a company could avoid by purchasing, rather than duplicating, a similar R&D effort."

I would also caution against the use of optimistic, unsupported turnover and profit projections in valuations. Despite "expert" advice to the contrary, SARS is often permitted to refer to subsequent "actual figures" to test the reasonableness of managements' opinions:

"It is permissible to consider subsequent events to the extent that they may clarify or provide additional information with regard to the information available at the date of the valuation" (Trustees of Johan Thomas Salvesen, a UK case)

In the event that an obviously fatally flawed valuation is queried by SARS, it does not assist the taxpayer to obtain numerous "independent, objective opinions" from "IP valuation experts" that provide hollow support for the valuation. Instead of obtaining "opinions" confirming that the "valuation methodology is common and must therefore be reasonable", rather spend the time trying to justify the methodology using valuation principles. Ultimately, this will need to be done, whether at the assessment stage or in Court. Alternatively, spend time settling the matter.

(Updated 2007)

Articles: Valuation