“Royalty stacking” results from an incorrect application of “the 25% Rule”. The best way of explaining this concept is by way of example:
Opco uses trademarks, patents, designs, copyright and know-how in its business. Opco wishes sequentially to assign each category of intellectual property (IP) to a wholly-owned subsidiary (IPSub) (possibly using the corporate rules) and licence the IP back to itself. As a first step, Opco determines reasonable royalties for the licences. Assuming that Opco generates R100m in turnover and R20m in profits before interest and tax, OpCo calculates reasonable royalty rates for:
- the trademark at 25% of profit before interest and tax (PBIT), i.e. 5% of turnover;
- the patent at 25% of PBIT, i.e. 25%xR15m/R100m = 3.75% of turnover
- the designs at 25% of PBIT, i.e. 25%xR11.25m/R100m = 2.81% of turnover
- the copyright at 25% of PBIT, i.e. 25%xR8.4375m/R100m = 2.11% of turnover
- the know-how at 25% of PBIT, i.e. 25%xR6.328m/R100m = 1.582% of turnover
The sum of all royalties payable by Opco to IPSub is 15.254% of turnover, or 76.27% of profits! Viewed from any angle, the total royalty is excessive – overvalued by more than 200%.