IP valuations ‐ unintended consequences

Over the years, many companies have valued their intellectual property (IP). Whether these valuations were for the purposes of determining a CGT base cost or claiming s11(gA) / s11(gC) allowances following acquisitions or mergers, taxpayers were typically interested in achieving the highest value possible. But is the attainment of this goal in the best interest of the parties? A high valuation may satisfy the short‐term goal, but possible unintended consequences may reverse the benefit in the medium to long term.

Most IP valuations in South Africa are prepared using the relief from royalty methodology. In determining the value, the parties must (among other inputs) determine: a reasonable profit‐split for the use of the IP (assuming that the IP is owned by an independent third party); and a reasonable discount rate.

If the owner's intention is to maximize the short‐term benefit, his interests will tend to apply upward pressure on the profit‐split and downward pressure on the discount rate ‐ while hopefully remaining within the bounds of reasonableness.

Where the valuation was prepared for CGT purposes, the valuation certificate would have been signed by the public officer, who in doing so would have confirmed the reasonableness of the valuation (and therefore the inputs).

Let's assume that in the medium term, it comes to SARS' attention that similar IP is used by foreign subsidiaries. This naturally leads to a transfer pricing inquiry and SARS calls upon the IP owner to justify the royalty payable (or, in most instances, the failure to make royalty payments) by these subsidiaries for the use of the IP. The knee‐jerk reaction is to claim that the IP has no value. Assuming that the company maintains this position and finds itself before our Tax Court, when put in the witness box, how will the Public Officer respond to a question inquiring into the reasonable profit‐split payable by the subsidiary for the use of the IP? After accounting for various factors, including relative advertising and marketing expenditure, how can the Public Officer claim that a profit‐split substantially lower than the profit split used in the CGT valuation is reasonable? He quickly finds himself in an invidious position:

Moving now to the long term, where after having traded successfully for a few years, the company wishes to sell the business as a going concern. The transaction requires the IP to be re‐valued for CGT purposes. Surely, similar inputs used in the CGT base cost valuation should apply. So, SARS could merely refer to previous valuation reports and revalue the IP using a similar profit split and unsystematic risk premium (extracted from the discount rate). Where these factors previously inflated the value of the IP, their inflationary effect is now compounded.

Finally, considering trademarks "depreciated" prior to 29 October 1999 in terms of s11(gA) of our Tax Act. These depreciation claims were often based on unreasonably high valuations. In fact, this section was abused to such an extent that trademarks were specifically excluded from s11(gA) in 1999. Accordingly, should the company now wish to sell its business as a going concern, the parties will naturally try to attribute as little value to the trademarks as possible (even if it means redirecting value to goodwill) ‐ the purchaser is unaffected thereby as no allowances are in any event available, and the seller escapes possible recoupment of allowances previously claimed. Assuming now that the seller consequently values the trademarks at a negligible value, can SARS not refer to the CGT / s11(gA) valuations and apply the same inputs to revalue the trademarks as at the date of sale and "re‐apportion" the sales price? If it does so, will SARS not overvalue the trademarks? Most probably, but it may not lie in the mouth of the seller to dispute the reasonableness of the revised value. Effectively silenced from challenging SARS' revaluation, the seller may well find itself liable for a significant recoupment flowing from the sale.

(Updated 2007)

Articles: Valuation