© 2009 Cassels Brock Tax Treatment of The Sale and Acquisition of Intellectual Property Lorne...

© 2009 Cassels Brock

Tax Treatment of The Sale and Acquisition of Intellectual Property

Lorne Saltman

Federated Press CourseJune 3, 2009

© 2009 Cassels Brock 2

General Comments on Intangible Property

In the modern world of business, the main force of economic activity and growth is intangible or intellectual property

Critical questions arise: how do you identify intangibles, separate them from other sources of income, and impose tax appropriately?


Outline of Presentation

• Tax Treatment of Costs of Acquisition, Development and Use of IP

• Tax Treatment of Receipts for Exploitation of IP

• Sale versus Lease Transaction

• Acquiring IP From a Non-Resident

• Transferring IP Offshore


Meaning of “Intellectual Property” for tax purposes

The terms “intellectual property” and “intangibles” are often interchangeable

It is often said that an intangible must be directly observable and commercially transferable


Meaning of “Intellectual Property” for tax purposes

Intangibles can be classified into • Manufacturing intangibles, e.g. patents,

inventions, trade secrets, formulae, processes, designs, patterns or know-how; and

• Marketing intangibles, e.g. trademarks, brand names, symbols or pictures having an important promotional value for the product concerned, copyright, franchises, licences, distribution channels, methods, systems, studies, forecasts, customer lists or technical data relating to marketing


Costs of Acquisition, Development and Use of IP

The principles governing the determination of whether an expenditure for developing, acquiring or using IP is fully deductible for purposes of the Income Tax Act (Canada) are essentially the same as for other types of expenditures



• A taxpayer’s income from a business or property is the taxpayer’s profit from that business or property for the year

• Generally, income from a business is determined in accordance with well-accepted principles of business, accounting or commercial trading

• Accordingly, ordinary business expenses, the deduction of which is not otherwise prohibited by a specific provision of the ITA, may be deducted in computing income from a business



• No outlay or expense is deductible unless it is made or incurred for the purpose of gaining income from a business or property

• No outlay or payment on account of capital is deductible except as specifically permitted by the ITA



• An amount payable (whether by lump sum or by instalments) for the acquisition at one time of all, or substantially all, of the rights associated with IP will be a capital expenditure, unless the IP at the time of acquisition has a short-term anticipated life



• Conversely, royalties paid for the use of IP owned by another typically are deductible as an ordinary business expense



• Inventory of a taxpayer can include IP

• Accordingly, where a taxpayer’s business includes the development or acquisition of IP on income account, the costs associated with such IP are deductible at the time not of acquisition but of disposition



• In computing a taxpayer’s income on an accrual basis for a taxation year from a business or property, no deduction may be made for an outlay or expense to the extent that it can reasonably be regarded as having been made or incurred as a royalty in respect of a period after the end of the year



• The costs of developing, acquiring or using IP may be on capital account and may be included within one of the depreciable classes in the Income Tax Regulations

• Capital cost allowance may be claimed by the taxpayer based on the rate of the applicable class on a declining-balance basis



• A patent, franchise, concession or licence for a limited period, except for a licence to use computer software, may be included in Class 14 of the ITR

• The amount of CCA is determined by apportioning the capital cost of each asset in the class over its life remaining at the time the cost was incurred (may be straight-line or another method that is reasonable)


Cost of Patents

• Property that is a patent or a right to use patented information for a limited period or unlimited period that is acquired on capital account is included in Class 44

• The undepreciated capital cost of Class 44 is eligible for CCA on a 25% declining-balance basis


Cost of Patents

• One would elect Class 14 over Class 44 if the remaining life of the patent under the licence is short, resulting in a higher CCA claim


Cost of Patents

• Where the capital cost of a patent is determined by reference to the use of the property, the taxpayer may apportion the capital cost of the property between the part dependent on use and the part not dependent on use

• The capital cost that is dependent on use may be deducted in full as CCA. The part that is not dependent on use may be deducted as CCA in the normal manner


Cost of Patents

Assume patent price is $1,000 plus royalty of 10% of revenues, resulting in additional $1,000 annual payments

Year One

(1/2 rate)

Year Two

Customary CCA deduction

2,000 x 12.5% =

250

1,750 + 1,000= 2,750 x 25%=

687.50

Optional CCA deduction

1,000 x 12.5% = 125, plus 1,000 =

1,125

875 x 25%= 218.75, plus 1,000 =

1,218.75


Cost of Patents

• The capital cost of a patent will include not only legal expenses incurred in applying for the patent, but also costs incurred to develop the invention to the point of application

• However, the capital cost of a patent will not include any costs incurred to develop the invention which have been included in the taxpayer’s SRED or which have been properly deducted as ordinary operating expenses


Cost of Patents

• In the CRA’s view, an expenditure made to acquire a patent will be an eligible capital expenditure if the expenditure does not result in the acquisition of a depreciable property


Deductibility of Eligible Capital Expenditures

• A taxpayer may deduct in computing income from a business an amount up to 7% of its “cumulative eligible capital” at the end of the year

• The taxpayer’s CEC generally includes three-quarters of all eligible capital expenditures made or incurred by the taxpayer in respect of the business, and is reduced by all deductions of CEC previously made by the taxpayer, and by three-quarters of the net proceeds from dispositions of eligible capital property


Costs of Copyright

• Copyright that is acquired during a creator’s lifetime will not qualify for Class 14, because the remaining life of the copyright is indeterminate

• However, copyright that is acquired after the creator’s death or during that person’s lifetime under a limited-term licence should qualify for Class 14


Costs of Computer Software

• A licence to use computer software is specifically excluded from Class 14

• Most computer software other than systems software will qualify as Class 12 property for which the CCA rate is 100%, where the software is capital in nature • The half-year rule is suspended for qualifying

acquisitions of computer software between January 27, 2009 and February 2011.



• Computer software is defined to include a right or licence to use computer software, but is not considered by the CRA to include a contractual right or licence of a capital nature to buy and resell, to sublet or to otherwise market computer software

• Such a contractual right is considered a Class 14 property if it is for a limited life or eligible capital expenditure if the life is indeterminate



• Systems software typically falls within Class 10 at a 30% CCA rate, although another class may apply depending on the connection with property of that other class • The rate is increased to 100% for qualifying

acquisitions of computer systems software between January 27, 2009 and February 2011.


Costs of Trade-Marks

• A trade-mark has an indefinite life and so cannot qualify for Class 14

• The CRA does not consider that it constitutes a depreciable property that comes within any class in Schedule II of the ITR

• Rather, its cost will be either an ordinary expense if on income account or eligible capital expenditure if on capital account


Costs of Trade Secrets and Know-How

• Unregistered trade secrets or know-how likely will not qualify for Class 14 treatment, because the rights associated with their use may have an indefinite life, and because know-how is not considered property

• The cost of a trade-secret that is acquired on capital account usually will be an eligible capital expenditure


Expenditures on Scientific Research & Experimental Development

• The costs of an ongoing nature incurred by a taxpayer to develop IP may be fully deductible when incurred, in accordance with the judicial principles decided under ss. 9(1)

• However, s.37 establishes a specific code for the deduction of SRED



• S. 37 expands the range of deductions immediately available to a taxpayer by including qualifying capital expenditures that otherwise might only be deductible over time as CCA or cumulative eligible capital amounts

• Also, s. 37 provides for the calculation of an expenditure pool for SRED that effectively gives the taxpayer the option of deducting an SRED expenditure in a subsequent year rather than in the year of the expenditure



• S. 37 is supplemented by • s.127 which provides an investment tax

credit for a somewhat narrower range of expenditures than under s.37, and

• s. 127.1 which may permit the taxpayer to receive a refund of all or a portion of ITC’s earned by it even where it has no current tax liability against which to deduct the ITC


Payment for Restrictive Covenants

• The term “restrictive covenant” covers not only non-competition covenants, but also an agreement entered into, an undertaking made, or a waiver of an advantage or right by the taxpayer (other than an agreement or undertaking for the disposition of the taxpayer’s property) that affects, or is intended to affect, the acquisition or provision of property or services by the taxpayer or by another taxpayer that does not deal at arm’s length with the taxpayer


Payment for Restrictive Covenants

• Where an amount is paid for a restrictive covenant in conjunction with acquisition of a business, the payer of the amount may make a joint election with the recipient, and will be allowed to include the payment in the cost of ECE


Receipts for Exploitation of IP

Both the way IP is exploited and the form of consideration received for its exploitation affect the tax treatment of the proceeds received



• Revenue realized from exploiting IP that is the focus of the taxpayer’s business will generally be taxed on income account, regardless of whether the taxpayer sells the IP, assigns rights to different markets on an exclusive or non-exclusive basis, or licenses the IP for a royalty



• For a disposition of IP to be considered on capital account, the taxpayer must in fact part with some of its property and, thus, must grant to the recipient some degree of exclusivity in the IP



Royalties or other amounts on income account will be included in income under ss. 9(1) in the year of receipt, if the taxpayer has an absolute entitlement to the amount and is subject to no restriction as to its disposition, use or enjoyment



An amount may alternatively have to be included in income under par.12(1)(a) if received in the course of a business on account of services to be performed after the end of the year, or for any other reason may be regarded as not having been earned in the year



A reasonable reserve may be deducted under paragraph 20(1)(m) for amounts included in income under 12(1)(a), in respect of goods or services that may reasonably be anticipated will be delivered or rendered after the end of the year, or for periods for which rent or other amounts for the possession or use of chattels (including IP contractual rights in certain cases) have been paid in advance



This reserve will be available, for example, where a licensor of IP is required during the term of years of the licence to perform ongoing services, such as protecting the licensee’s lawful rights in the specified territory to use the licensed IP



Where consideration receivable for the disposition of IP is an amount that varies depending on the production or use made of the property, paragraph 12(1)(g) may deem all proceeds to be income to the taxpayer, notwithstanding that the transaction otherwise would be considered to have occurred on capital account



The following principles reflect the jurisprudence and the CRA’s administrative practice:• Where all the payments under the

agreement of sale are based on production or use, those amounts are brought into income when received by the taxpayer;



• Where the agreement provides for the payment of a fixed sum, plus an additional amount should production or use exceed a stipulated figure, the fixed sum will be treated as proceeds of disposition and the additional amounts, if any, will be brought into income



• Where the agreement provides for payments based on production or use and also stipulates a minimum sale price, or minimum annual payments, the payments based on production or use are brought into income, irrespective of whether they are less than or exceed the minimum amount; however, any other payments which must be made in order to achieve the minimum requirements are treated as proceeds of disposition



• Where the agreement calls for payment of a fixed sum, but the timing of the payments of that sum varies depending on production or use, paragraph 12(1)(g) does not apply



• Where the sale price is an amount equivalent to the fair market value of the property at the time of the sale, but can be decreased if certain conditions relating to production or use are not met in the future, the maximum amount will be considered to be the proceeds of disposition, provided there is a reasonable expectation at the time of disposition that the conditions will be met


Receipts for Exploitation of Intangibles

• Where on a sale of IP, a portion of the sale proceeds is allocated (or should have been allocated) to a restrictive covenant provided by the taxpayer, that allocated amount may be deemed to be income under proposed s.56.4


Receipts for Exploitation of Patents

• Amounts (including lump sums) received for the granting of a non-exclusive license to use patents have been found to be income receipts.

• A lump sum received for granting an exclusive license to exploit a patent within a specified area may be a capital receipt, provided that the taxpayer’s business does not include buying and selling patent rights, or otherwise dealing in patents


Receipts for Exploitation of Copyright

• A distinction has been drawn between compensation received by a writer or artist for his/her services in creating a work which is clearly taxable as ordinary income, and the sale by a person of the copyright to a work, which in some circumstances can give rise to a capital receipt



• A receipt by a writer or artist may be on capital account where the payment is received after that person ceases their career or in connection with the cessation of their business

• Proceeds received on the sale of copyright out of the ordinary course of business (for example, the sale price received by a publisher selling all the assets of its business as a going concern) normally would be received on capital account



Because computer software developers normally retain copyright, proceeds received by them from licensees generally will be on income account.


Receipts for Exploitation of Know-How

• The CRA’s view, based on the jurisprudence, is that proceeds from outright sale of know-how will be considered proceeds from the disposition of eligible capital property, whereas if knowledge is not sold outright but merely licensed for a limited period of time, or its use is permitted under the terms of a non-exclusive licence, the total proceeds for the right to use the trade secrets will be considered income from exploiting the IP or from rendering services


Capital Receipts for Exploitation of IP

• Proceeds of disposition of IP that is depreciable property, as reduced by applicable outlays and expenses, will be deducted from the undepreciated capital cost of the appropriate class of depreciable property to the extent that such net amount does not exceed the capital cost of such property



• To the extent that such deductions result in a negative balance at the end of the year, that balance of “recaptured depreciable” will be included in the taxpayer’s income.

• If there is a positive UCC of a class following the disposition of all the depreciable properties of that class, that balance usually can be deducted as a “terminal loss”



• Any excess of proceeds of disposition of a depreciable property over its capital cost and applicable outlays or expenses will be accounted for separately as a capital gain. No capital loss may be recognized on the disposition of a depreciable property



• Eligible capital amounts received are deducted from the balance of a taxpayer’s cumulative eligible capital in respect of a business at three-quarters rates

• Cumulative eligible capital generally includes three-quarters of all eligible capital expenditures made or incurred by the taxpayer in respect of the business



• Eligible capital amount includes three-quarters of an amount received by a taxpayer on account of capital in respect of a business, other than an amount that • is included in computing the taxpayer’s income, or

deducted in computing any balance of undeducted outlays, expenses or other amounts,

• reduces the cost or capital cost of property or the amount of an outlay or expense, or

• is included in computing any gain or loss of the taxpayer from a disposition of a capital property



• Where eligible capital amounts received are credited against the taxpayer’s cumulative eligible capital resulting in a negative balance at the end of a year, that amount will generally be included in the taxpayer’s income from the related business at capital gains rates


Sale Versus Lease Transaction

• Prior to 2001, CRA’s IT-233R stated that where a lease had a purchase option with an exercise price at less than fair market value, the lease would be considered a sale

• This was intended to curb abuses in leases where the substance of the transactions disclosed that the parties intended to effect a sale



• Supreme Court held in Shell Canada Limited v. The Queen and other decisions that the economic realities of a situation cannot be used to recharacterize a taxpayer's bona fide legal relationships

• Absent a specific provision of the ITA to the contrary or a finding that there is a sham, the taxpayer's legal relationships must be respected in tax cases.



• The determination of whether a contract is a lease or sale is based on the legal relationship created by the terms of the agreement, rather than on any attempt to ascertain the underlying economic reality

• Legal substance will be examined, so that if a lessee automatically acquires title to the property after payment of a specified amount of rentals, the legal relationship would be one of purchaser/vendor rather than lessee/lessor



• Notwithstanding the legal relationship, GAAR may be used to assess cases in which there is an avoidance transaction that results in a misuse or an abuse of provisions of the ITA


Sale of Shares of a Corporation Owning IP

• Matters to consider:• Personal and corporate tax integration when capital

gains or recapture realized by Canadian-controlled private corporation and distributed to shareholder

• Lifetime Capital Gains Exemption now $750,000. But “qualified small business corporation shares” depend on value derived from IP used in “active business”

• Earn-out treatment for capital gains on disposition of shares versus income treatment under par. 12(1)(g) if IP transferred directly and payment based on production or use


Acquiring IP From a Non-Resident

• Most payments made to non-residents for royalties on account of the right to use IP (other than copyright) in Canada will be subject to 25% withholding tax

• Canada’s tax treaties generally reduce the rate to 10% • In some treaties (e.g. with U.S.A.) an exemption

applies for payments for the use of, or the right to use, any patent or any information concerning industrial, commercial or scientific experience (but not including any such information provided in connection with a rental or franchise agreement)


Acquiring IP From a Non-Resident

• Withholding tax will not apply to proceeds of sale by non-resident

• Accordingly, a sale rather than license may only subject the non-resident to tax on business income

• Consider whether non-resident may be carrying on business in Canada, and

• If a tax treaty is applicable, whether the profits are attributable to a permanent establishment of the non-resident in Canada


IP Cost-Sharing Agreement

• Payment by a resident to a non-resident pursuant to a Cost-Sharing Agreement may avoid royalty withholding tax and transfer pricing issues

• Costs must be shared on a reasonable basis, and

• The Canadian resident must obtain some reasonable right to use the IP that has been developed


Transferring IP Offshore

• Propose to shift business and profits associated with IP to a low-tax jurisdiction

• Ideal to move IP offshore before its value increases significantly

• Transfer must occur at fair market value – should be well-documented and determined by an independent appraiser

• Consider alternative ways to transfer IP to a corporation resident in a low-tax jurisdiction along with associated risks

• Residency and location of the associated business of the transferee should be well-established

• Increased CRA enforcement activities


Presenter

Lorne H. Saltman Phone: 416 869 5386

Fax: 416 350 6912Email: [email protected]

© 2009 Cassels Brock

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