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How to work out royalties on intellectual property

by , 05 March 2013
Earlier today, a jury in the US sided with snack food group Medallion Foods after Frito-Lay's alleged the group had intentionally attempted to imitate its chips and infringed on its intellectual property rights, reports stltoday.com. While most business owners understand how intellectual property works, few realise the implications of getting intellectual property (IP) valuations wrong. Here's what you need to do to ensure your company's intellectual property valuations pass SARS' scrutiny...

It's widely believed that value of Coca-Cola's trademark, although intangible, exceeds the capital value of all of Coca-Cola's products and assets.

That's why Coca-Cola has done everything it can to protect the intellectual property behind its recipe.

And it's not the only company that's doing this.

'While Intellectual Property (IP), eg patents and trademarks, has always been valued, increasing recognition for this aspect has become well established, especially for asset registers in company balance sheets,' explains the SABS.

In fact, says SABS, 'realisation has gained ground amongst accountants and corporate executives that IP can form a significant proportion of the assets in some businesses.'

That's why if your company works with intellectual property you need to consider whether you're calculating royalties correctly or not…

Use the Relief from Royalty Methodology to pay royalties on intellectual property

'In South Africa, nearly all intellectual property 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,' explains the Practical Tax Loose Leaf.

However, it's important to note that this rule only applies where the intellectual property:

  • Is a driver of sales/profits;
  • Represents a relatively strong arsenal of assets;
  • Grants the holder protection against competition; and
  • Appears to be valid and enforceable.

Here's how to use the Relief from Royalty Methodology to calculate intellectual property royalties

Here are the four steps to using the Relief from Royalty Methodology as outlined by the Practical Tax Loose Leaf.:

  1. Determined the profit before interest and tax (PBIT) of the user and convert it into a percentage of turnover;
  2. Presuming that the intellectual property is owned by a third party, determine the reasonable notional royalty, based on a reasonable split of PBIT
  3. Forecast the turnover for the useful economic life of the intellectual property and convert this into notional royalties; and finally
  4. Discount the notional royalties using an appropriate discount rate to arrive at a present value of the intellectual property.

According to 'the 25% Rule', the royalty rate is generally expected to fall within the range 20% to 33% of PBIT.

But be warned, says SARS: '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.'

So make sure you work out your royalty payments for intellectual property correctly to avoid coming under scrutiny from SARS.

For more information on royalty payments, get your hands on the Practical Tax Loose Leaf. In the Practical Tax Loose Leaf we've got a dedicated chapter on royalty payments. In it you'll discover:

  • The capital and revenue nature of royalty payments
  • Running royalty payments
  • Upfront royalty payments
  • International IP licences present many challenges – don't be caught out!
  • South African source royalty income
  • Transfer pricing tips
  • 4 quick tips to remember when considering royalty payments
  • Exclusive licences are both revenue and capital in nature
Get the Practical Tax Loose Leaf here...

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