What Is the Relief From Royalty Method?

The Relief from Royalty (RFR) method is an income-based approach used to determine the value of an intangible asset. An asset’s value is considered equivalent to the present value of the royalty payments the owner avoids by owning the asset instead of licensing it from a third party. This valuation technique is applied to intellectual property such as trademarks, brand names, patents, and developed technology.

Core Components of the Calculation

A primary component is the projection of future revenue attributable to the intangible asset. This requires a forecast of the income stream the asset is expected to generate over its useful life. Isolating the asset’s direct contribution to revenue is important, as most royalty agreements are structured as a percentage of sales.

Another element is selecting an appropriate royalty rate, which is the hypothetical percentage of revenue that would be paid to license the asset. This can be determined through a market approach by analyzing licensing agreements for comparable assets. Databases that track royalty rates across industries are consulted to find arm’s-length transaction data to support the chosen rate.

The Remaining Useful Life (RUL) of the intangible asset must also be established, as this determines the forecast period. The RUL is the time over which the asset is expected to generate economic benefits. For assets like patents, the RUL may be defined by legal statutes, while for trademarks a finite period is projected for valuation purposes. This timeframe impacts the number of years for which royalty savings will be calculated.

Finally, a discount rate is determined to convert the future stream of royalty savings into a single present value. This rate reflects the risk associated with the asset’s projected cash flows. A common starting point is the company’s Weighted Average Cost of Capital (WACC), which is then adjusted for the specific risks of the intangible asset.

The Valuation Calculation Step-by-Step

The first step is to determine the pre-tax royalty savings for each period within the asset’s RUL. This is calculated by applying the selected royalty rate to the projected revenue for each year. The formula is: Projected Revenue x Royalty Rate = Pre-Tax Royalty Savings.

Next, the pre-tax savings are adjusted for taxes to find the after-tax savings. This is done by multiplying the pre-tax savings by one minus the applicable corporate tax rate. For example, if the pre-tax saving is $100,000 and the tax rate is 21%, the after-tax saving would be $79,000.

The final step is to calculate the present value of this stream of after-tax royalty savings. Each year’s after-tax saving is discounted back to its value in today’s dollars using the predetermined discount rate. The sum of all discounted future cash flows provides the intangible asset’s value.

Incorporating the Tax Amortization Benefit

An additional component of value is the Tax Amortization Benefit (TAB), which is the present value of income tax savings from the amortization of the intangible asset. When an intangible asset is acquired in a business combination, its value can often be amortized for tax purposes over a statutory period, such as 15 years under Section 197 of the U.S. tax code.

This tax amortization creates a non-cash expense that reduces the company’s taxable income and lowers its cash tax payments. The TAB calculation quantifies this stream of future tax savings in present value terms.

The present value of the TAB is added to the present value of the after-tax royalty savings calculated in the primary RFR analysis. Including the TAB captures all sources of cash flow benefit related to owning the asset.

Common Applications in Business and Finance

The RFR method is used in financial reporting for purchase price allocations under Accounting Standards Codification 805. When one company acquires another, the purchase price must be allocated to the tangible and intangible assets acquired. The RFR method is used to value intangibles like brand names or patented technology and for later impairment testing under ASC 350.

For tax and transfer pricing, the RFR method helps establish arm’s-length royalty rates for transactions between related corporate entities. Tax authorities require that cross-border transactions involving intellectual property be priced as if they were between unrelated parties. The RFR framework provides a defensible methodology for determining these royalty rates.

The RFR method is also applied in litigation support for intellectual property disputes. In a patent or trademark infringement case, the method can calculate economic damages. It determines the value of a hypothetical royalty the infringer would have paid, establishing a basis for financial restitution.