Use of the 25% Rule

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.

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. Abuse of this methodology was highlighted in “Fundamentals of Intellectual Property Valuation”, published by the American Bar Association at p35:

“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.”

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).

This methodology is typically not applicable to the valuation of copyright in 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.

Another mistake often made 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, a reasonable royalty should properly be determined 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%!

The potential material effect caused by royalties payable must surely raise concerns when relying on benchmarking reports, where royalties payable is seldom accounted for.

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