Tax structures that abuse the notion of intellectual property (IP) have been growing in popularity since the late 1990s. But most people don't realise how badly these structures can damage businesses and investments.
It's not just the taxman that is fleeced. In the end, the shareholders and competitors of the companies using the structures suffer too.
In my opinion, companies benefiting from abusive IP structures are building empires out of sand castles: the castles are set up to besiege and take over smaller competitors, while offering a false sense of security to innocent investors sheltered therein.
To illustrate, let's consider a hypothetical scenario involving a company called PollyCo. PollyCo is a listed packager and distributor of no-name birdfeed. It generates R100m/year in revenue and R15m/year in profits before interest and tax, and (like its competitors) is taxed on its profits at the rate of 29%. PollyCo imports the packaging equipment used in its business and sources its grain from wholesalers. It competes on price alone and has no material IP (whether trademarks, patents, designs, know-how or copyright). PollyCo has created a small spreadsheet containing the names and contact details of all 76 retailers of birdfeed, which we'll call "the database".
One day, the company is approached by a financial adviser, who proposes to "unlock" the value in PollyCo's IP. An intellectual property practitioner "audits" the IP and finds only the copyright in the database. Not disheartened by this meagre IP trove, the practitioner values the IP asset, using the relief from royalty methodology, at R87,5m.
Initially expressing surprise at this unexpectedly high value, PollyCo is comforted by the practitioner's guarantees that this methodology is the most common one used to value IP and that it is accepted by the SA Revenue Service (Sars).
PollyCo accepts the valuation and is then persuaded to use the IP (which has been transformed and is now referred to as "software") in a tax structure that generates R87,5m in deductions over five years. The transaction is structured so that all payments are either circuitous or set off, having no cash flow implications for any of the parties involved.
In essence, PollyCo's business operations are not affected by the transaction, but PollyCo will now enjoy five years of tax-free trading.
PollyCo passes this tax saving on to its customers and reduces the price of its products by 4,35%. To retain their market share, competitors are forced to follow suit and join the price war. However, whereas PollyCo's profits are unaffected by its reduction in sales price, the profits of its competitors fall by about 29%.
Over time they surrender market share to PollyCo. What's more, their reduction in earnings and dividend distributions apply downward pressure on their share prices. And it is only a matter of time before some competitors become attractive acquisition targets for PollyCo, which has entrenched itself as a dominant player in the market.
Nearly five years later, the increase in PollyCo's market share and maintained earnings relative to its competitors has caused its share price to increase and trade at a premium relative to its competitors.
Innocent investors purchasing PollyCo shares are unaware of the pending termination of the five-year tax holiday. After the fifth anniversary of the transaction, high tide reaches the castles and PollyCo's earnings "unexpectedly" decline by 29%, which is followed by a sharp fall in the share price and an overdue levelling of the competitive playing field. To add insult to injury, the shareholders are expected to foot the bill relating to directors' share options that "timeously" matured just before the fifth anniversary.
For many of PollyCo's competitors, the effects of the price war prove irreversible and permanent.
Granted, the above hypothetical example requires a mix of: aggressive financial advisers; unethical valuators; credulous and unscrupulous directors; inattentive shareholders; and a tax regulator that is either unresponsive or slow to respond. This combination is not uncommon.
My advice to companies is to beware of abusive IP tax structures: you may find yourselves answerable to Sars and hostile shareholders.
- Van Zantwijk is a partner at Sibanda & Zantwijk, which specialises in IP management
