Article by Nigel Eastaway, Senior Tax Consultant, WJB Chiltern, published in the May 2001 issue of Tax Adviser. A worked example is attached in Adobe (pdf) format.
Since the 1998 Budget the Government has been consulting on changes to the taxation law relating to intellectual property as part of the campaign to increase the amount spent on research and development by British business. These changes are likely to mean that the need to value intellectual property for tax and accounting purposes will become more common in future.
The Revenue in their Technical Note Reform of the Taxation of Intellectual Property stated that ‘… we think intellectual property includes the following, but the list may not be comprehensive:
• trademarks and servicemarks and brand names;
• copyrights and design rights, this includes films and computer software for registered designs;
• performer’s rights;
• know-how (both industrial and commercial);
• database rights;
• plant breeding rights.’
Although the emphasis in the latest Technical Note (Taxation of Intellectual Property, Goodwill and other Intangible assets: The New Regime published on 7 March) extends the proposed changes in tax law to include goodwill and other intangible assets, this article looks purely at the problem of valuation of intellectual property rights. The new regime is likely to be based very much on accounting standards and generally accepted accounting principles. The guidance in relation to the valuation of intellectual property is sparse. FRS 7, relating to fair values in acquisition accounting, merely states ‘where an intangible asset is recognised its fair value should be based on its replacement cost which is normally its estimated market value’. FRS10, covering goodwill and intangible assets, at para. 12, states:
‘… it is not possible to determine a market value for unique intangible assets such as brands and publishing titles. Replacement costs may be equally difficult to determine directly. However certain entities that are regularly involved in the purchase and sale of unique intangible assets have developed techniques for estimating their values indirectly and these may be used for initial recognition of such assets at the time of purchase. Techniques used can be based, for example, on indicators of value such as multiples of turnover or on estimating the present value of the royalties that would be payable to license the asset from a third party.’
Paragraph 13 continues ‘if its value cannot be measured reliably, an intangible asset purchased as part of the acquisition of a business should be subsumed within the amount of the purchase price attributed to goodwill’.
Paragraph 14 states ‘an internally developed intangible asset may be capitalised only if it has a readily ascertainable market value’. The problem with this approach is that it is not uncommon for a company’s most valuable assets to be intellectual property and to exclude any value from the balance sheet merely because it may have been developed internally, perhaps encouraged by the Government’s research and development credits, seems unhelpful as the balance sheet does not then show the true value of the business. It seems that the trend in accounting principles is in favour of including all assets at fair value and it may be that, in future, estimating the market value of intellectual property will become even more important for accounting purposes.
It is already important to consider the market value of intellectual property rights for taxation purposes on cross-border sales or licensing, both for double taxation treaty purposes where tax credit relief is normally limited to the commercial royalty, and for national transfer pricing rules. It is beyond the scope of this article to consider problems arising from different interpretations of these rules (such as the US transfer pricing rules relating to super royalties or royalties commensurate with income, whereas most other jurisdictions work on the market value).
FRS10 recognises that in certain industries valuation techniques have been developed – for example, a multiple of the three-year average of royalties generated under a popular music publishing catalogue. The multiple may be between, say, three and 15, depending on the quality of the artistes involved and their perceived longevity in commercial terms, so, as in all valuation, there is very much a subjective judgement involved in the absence of direct comparables.Intellectual property being, by definition, largely unique, it is not easy to arrive at meaningful comparables.
Intellectual property is a negative right in that it gives the owner a right to prohibit others from copying without permission what has been created. It does not generate any income unless it is exploited, for example, by incorporation in a product or service which is sold. For example, a drug company may invest in research and development to produce a new drug that is the subject of a patent application, which is then converted into a marketable product taking advantage of the company’s know-how in drug production and exploiting its reputation in the market through brand names or trade marks; or a publishing company may commission a work, or acquire a copyright for a book which is then produced and sold. Intellectual property, however, may also be assigned outright or licensed on an exclusive or non-exclusive basis for the remaining life of the intellectual property or for a limited period or limited production.
The first stage in valuing intellectual property is to identify the rights being valued, Borlands’ Trustee v Steel Brothers & Co Ltd (1901) 1 Ch 279, Short v Treasury Commissioners (1948) 1 KB 116. It is then necessary to determine the market value of those rights, i.e. the price which the property might reasonably be expected to fetch if sold in the open market at that time (IHTA 1984, s. 160, TCGA 1992, s. 272). The term ‘open market’ includes a sale by auction but is not confined to that (IRC v Clay and IRC v Buchanan (1914) 3 KB 466). ‘A value ascertained by a reference to the amount obtainable in an open market shows an intention to include every possible purchaser. The offer is to the open market as distinguished from an offer to a limited class only such as members of the family.’
This was described in Re Lynall, Lynall v IRC (1971) 47 TC 375 in the following terms:
‘There may be different markets or types of markets for different types of property but … the market which must be contemplated, whatever its form, must be an open market in which the property is offered for sale to the world at large so that all potential purchasers have an equal opportunity to make an offer as a result of it being openly known what it is that is being offered for sale, mere private deals on a confidential basis are not equivalent to open market transactions.’
In the case of intellectual property it is quite common for there to be a special purchaser who has a particular interest in the acquisition of the property, either to improve the value and profitability of current production or to keep out competitors. Special purchasers have to be considered in arriving at the market value, where the existence of a special purchaser is known or can reasonably be inferred, on the reasoning that this would push up the price by dealers entering into the market to try and make a profit on on sale to the special purchaser. This line of argument was considered in a series of cases, including IRC v Clay, IRC v Buchanan (1914) 3 KB 466, Glass v IRC (1915) SC 449, Raja Vyricherla Narayana Gajapatiraju v Revenue Divisional Officer Vizagapatam (1939) AC 302, Robinson Brothers (Breweries) Ltd v Houghton and Chester-le-Street Assessment Committee (1938) 2 All ER 79, and Hawkings- Byass v Sassen (1996) STC (SCD) 319.
Arm’s-length sales of the same property, if truly arm’s-length, could give a useful indication of its value, (McNamee v IR (1954) IR 214) but sales subsequent to the date of valuation should be viewed with caution, IRC v Marrs Trustees (1906) 44 SLR 647.
Where intellectual property is being valued it may not be appropriate to value each item individually, as there may well be independent rights which are nevertheless interdependent in the sense that they relate to a single product or package. For example, a license agreement for a complex piece of machinery could well include features in its construction which would be subject to patent protection, or protected as design rights or registered designs, know-how relating to the manufacturing processes, copyright in the service manuals and licenses for the use of trade marks and brand names. Judicial authority for the valuation of assets as a package is found in cases such as Earl of Ellsmere v IRC (1918) 2 KB 735, Duke of Buccleuch v IRC (1967) 1 AC 506, Smyth v IRC (1941) IR 643, Trustees of Johan Thomas Salvesen v IRC (1930) 9 ATC 43 and Attorney-General of Ceylon v Mackie (1952) 2 All ER 775.
The valuation must be based on the information available at the time, not with the benefit of hindsight, Re Holt (1953) 32 ATC 402, although subsequent events may clarify the information which may have been available at the date of valuation, Buckingham v Francis (1986) 2 All ER 738, Re Bradberry, National Provincial Bank Ltd v Bradberry, Re Fry, Tasker v Gulliford (1943) Ch 35. An open market assumes a sale between a hypothetical willing seller and a hypothetical willing, prudent and cautious buyer, Re Lynall v IRC (1971) 47 TC 375, Caton’s Administration v Couch (1995) STC (SCD) 34, Clark v Green (1995) STC (SCD) 99, Findlay’s Trustees v IRC (1938) 22 ATC 437.
Present value of future earnings
In practice it is often appropriate to consider the earning capacity of the intellectual property rights being valued, by reference to a royalty which a third party would be prepared to pay to obtain the benefit of the rights. This means ascertaining a potential royalty level which may be available from government statistics, industry databases, market intelligence held by the owner of the rights, trade associations, industry publications, agents and dealers or the financial press. It may be possible to confirm the reasonableness of a royalty rate by considering the likely costings of the purchaser, to ensure that the anticipated royalty would give a reasonable margin to the purchaser and confirm the economic viability of the chosen royalty levels.
Each case has to be considered individually. There is no such thing as a general royalty rate for drugs, for example, or automotive components or a popular song because in each case it is necessary to estimate the likely market, the importance of the intellectual property and hence its likely earning capacity for the purchaser. There will be cases where the royalty level is normally within certain parameters – for example, with many non-fiction books the royalty level may be between ten per cent and 15 per cent, for popular songs the margin is much wider, say between three per cent and 35 per cent, for many products a royalty level of two per cent – three per cent of sales is common but ten per cent or 50 per cent may be justified in a particular case.
For tax purposes it may merely be necessary to calculate the royalty level to show that it is an arm’s-length receipt of the licensor where the parties are connected and in different territories, under transfer pricing rules, or is an arm’s-length payment by the licensee and wholly and exclusively incurred for the purposes of the trade. A similar exercise may be necessary to show that a royalty level is commercial, for the purpose of any double taxation treaty provisions.
It may be necessary to arrive at the capital value of intellectual property on an outright assignment or sale for a lump sum, or to justify the value of the property for a venture capitalist or lending bank. The capital value is the present value discounted at a rate of interest which takes into account market levels of interest, and an additional element for risk, applied to the best estimate of the likely future royalty receipts. The value of an asset being the present value of future earnings is endorsed by FRS 10 for accounting purposes and is commonly met within the valuation of other intangibles such as goodwill and unquoted shares. An example of a valuation prepared on this basis follows below.
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May 2001 by