Valuation Methods: The Relief-From-Royalty-Method

Reliance on the relief-from-royalty-method – a brief classification

The relief-from-royalty-method is a well-established valuation technique based on net present value principles.

It is widely used in particular for brand valuation, but also for patents and technologies. A common application involves purchase price allocation for business combinations under International Financial Reporting Standards (IFRS).

This method is also widely used for tax purposes to determine the value of intangible assets and ensure accurate tax compliance.

Relief-from-royalty-method – the basic idea

The relief-from-royalty method is a valuation approach that estimates the value of an intangible asset based on the hypothetical royalties a company would incur if it lacked ownership and needed to license the asset from an external party.

These implied license savings reflect the asset's value contribution.

To apply the relief-from-royalty-method, two primary steps are necessary:

• Determining the Appropriate License Rate: The goal is to establish a license rate that would be agreed upon by independent parties in an arm's-length transaction. This rate should reflect the specific attributes of the intangible asset, including its useful life, geographic scope, and competitive landscape.
• Determining the Base Amount: The license fee is calculated based on an appropriate base amount, such as the net revenue generated by the use of the intangible asset. This base amount serves as the foundation for calculating annual license payments.

The intangible asset's value is determined by calculating the present value of future tax-adjusted license savings. This involves discounting future payments to the present day to account for the time value of money.

Relief-from-royalty-method - requirements for application

To determine the value of a brand using the relief-from-royalty method, three key elements are required:

• A comprehensive financial forecast estimating the brand's associated expenses and revenues.
• Benchmarks from similar brands regarding license fees, durations, and contractual terms.
• Data on the cost of capital, or discount rate, used to calculate the present value of future royalty payments.

To apply the relief-from-royalty-method, the following steps are typically followed:

First, comparable licenses are identified by considering factors such as industry, region, brand type, and useful life. An average license rate is then calculated based on these comparable licenses. Finally, this rate is discounted to the present day to determine the brand's value.

The reliability of the valuation results depends on the quality of the data used, particularly the careful selection of comparable license agreements, which requires an in-depth understanding of relevant markets and industries.

The applicability of the relief-from-royalty method under IFRS and tax regulations

The relief-from-royalty method offers a relatively straightforward approach to valuing intangible assets, requiring a revenue forecast, a royalty rate, and a suitable cost of capital rate.

While IFRS provides some flexibility in choosing the royalty rate, tax law imposes more stringent requirements. This difference stems from the distinct objectives of these two legal frameworks.

• IFRS: Under International Financial Reporting Standards, the primary objective of valuation is to provide information to capital markets. The principle of prudence takes precedence, allowing companies some flexibility in selecting license rates as long as they appear reasonable and within a suitable range.
• Tax Law: In contrast, tax law focuses on determining the accurate tax base. Tax authorities scrutinize the chosen license rate closely, emphasizing the arm's-length principle to prevent artificial advantages or disadvantages and ensure transactions occur under normal market conditions.

Discussions with tax authorities are common, as determining a market-based license rate often involves subjective judgment due to the scarcity of directly comparable transactions.

Moreover, transfer pricing regulations must be adhered to, especially for intercompany license agreements, to prevent artificial profit shifting to low-tax jurisdictions.

Finally, taxpayers must provide detailed justifications and evidence for the chosen license rate, necessitating extensive documentation.

Conclusion: The relief-from-royalty-method in the context of valuation approaches

The relief-from-royalty-method is a valuable tool for valuing intangible assets, especially brands, patents, and technologies. By measuring asset value in terms of hypothetical license payments, it offers a transparent and understandable approach.

Applicable in both IFRS and tax law, the method's strength lies in its simplicity and ability to quantify intangible asset value.

However, its application presents challenges. Determining a market-based license rate can be subjective due to the scarcity of comparable transactions. Moreover, data quality is crucial for reliable results. Tax law imposes stricter requirements, particularly regarding the arm's-length principle and documentation.

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