Fundamental changes to the treatment of intellectual property for corporate tax purposes in the UK have recently been proposed. Draft provisions detailing the new rules have been published, with the new legislation being expected to apply from April 2002.
However, other than for royalties (the definition of which is considered in more detail below), the new rules will only apply to IP either created, or purchased from unconnected parties, after the date of commencement of the new rules. This will lead to an extended period during which the tax treatment applicable to the owner of IP will depend upon the date when the IP was acquired. Accordingly, this article covers both the existing rules and the proposed new rules for the UK treatment of IP.
EXISTING RULES
The existing UK rules have developed on a piecemeal basis over a number of years. Under these rules, before a company can determine the tax treatment of a transaction involving IP, it must analyze precisely the nature of the income or expense, and the type of IP involved. However, there are certain consistent themes in the existing UK rules, as set out below.
Whether a receipt or expense is revenue or capital in nature. In making this distinction, reference is made to wider UK case law distinguishing between revenue and capital items, with capital being broadly defined as "an asset or an advantage for the enduring benefit of the trade". Where the owner of the IP receives a payment for the use of IP, but retains ownership and the rights to exploit the IP, the income would generally be treated as revenue because the owner is sharing the rights to the IP. However, if the rights to the IP are relinquished, or partly relinquished, the transaction will be treated as capital, even if the ultimate legal ownership is retained. This is particularly true when the owner of the IP disposes of its entire interest for a single sum. Similarly, where the user pays for the rights to use IP for a particular period, as opposed to the unfettered right to exploit the IP, the expense is viewed as revenue rather than capital.
The above distinction is important in determining whether a receipt or expense is taxable or tax deductible in the year in which it arises (or in practice is paid, see below) – as is generally the case with revenue items – or whether an alternative capital treatment applies.
Revenue income, particularly expenses, are sometimes treated under the existing UK rules as being subject to taxation (relief) on an actual received (paid) basis. Such items would generally be classified as royalties under existing UK provisions, with certain royalties, notably those relating to patents, being tax deductible or taxable on a paid or received basis as opposed to an accruals basis. Lump-sum payments can fall within the royalty definition, and therefore effectively be treated as revenue payments. This treatment of lump-sum payments is based upon the UK case law interpretation that a lump-sum payment for the right to exploit IP over a period of time, or up to a certain level, can constitute a royalty. Royalty payments made by a UK company are subject to the income withholding tax at 22%, with treaty relief available provided an advance clearance application is made with the Inland Revenue. However, some royalties, particularly those for trademarks, are not normally subject to withholding tax.
For capital expenditure, the nature of the IP in question determines whether tax depreciation – known as capital allowances - are available or whether the asset would simply fall within the UK capital gains regime with no tax depreciation available. Generally on disposal, if tax depreciation was available for the initial expenditure on the asset, then there is a recapture of tax depreciation already claimed, and the taxation of any excess profit over and above the original acquisition cost. If the IP fell within the capital gains regime, the disposal proceeds would be taxable, subject to relief for the original acquisition cost, together with an inflation adjustment. Assets which fall within the capital gains regime are also subject to additional relief; in particular, the offset of capital losses from any other capital disposals, (ie not just of IP) and, importantly, rollover relief into a range of assets, including land, buildings and fixed plant and machinery, as well as goodwill, but not most forms of IP. The reinvestment which triggers rollover relief needs to be made between one year before and three years after the disposal occurred.
For UK capital gains purposes, there is a capital disposal of an asset when the beneficial ownership of the asset changes, as it is the beneficial ownership, rather than the legal ownership, that normally determines the timing of the taxable disposal.
Distinction between types of intangible assets
Current UK legislation requires a precise analysis of the nature of IP to determine the IP's tax treatment. In short, the UK legislation draws distinctions between the following types of IP:
Know-how: Technical know-how is defined under the UK tax legislation as "any industrial information and techniques likely to assist in the manufacturing or processing of goods or materials". This is to be distinguished from commercial know-how which is not specifically defined in UK legislation, but includes things such as market research, customer lists and sales techniques. Technical know-how has a more favourable tax treatment.
Patent rights: These rights include the right to apply for a patent and a license.
Copyright and related rights: These types of rights protect software and original literary, dramatic, musical, and artistic works, as well as sound recordings, programmes and rights in published works. Such rights can exist as a property right without being registered.
Trademarks and brand names: A trademark is essentially a symbol that is protected through registration. An unregistered trademark will usually be regarded as part of the goodwill of a business.
Goodwill: This is generally held to be "the benefit and advantage of the good name, reputation and connections of a business", and may well include the commercial know-how, assembled workforce etc.
The following table summarizes the availability of tax depreciation, and the treatment of disposals under the existing regime:
Type of IP |
Tax Depreciation |
Liquidation |
Know-how - technical commercial |
Yes No |
Revenue income disposal unless disposed of along with a UK trade (joint election can be made to prevent capital treatment) |
Patents |
Yes |
Revenue income / capital disposal depending on nature of disposal - possibility of spreading receipts over the next six years |
Copyright |
It is often possible to get relief on an accounting basis, and capital allowances are available for software |
Revenue income / capital disposal depending on nature of disposal |
Trademarks, brands |
No |
Revenue income / capital disposal depending on nature of disposal |
Goodwill |
No - through the rollover relief may be used to defer gains arising on other assets when good will is acquired |
Capital disposal (rollover relief available) |
NEW RULES
The proposed new UK tax regime for IP involves fundamental changes. The new regime aims to bring consistency to the tax treatment of IP, contrasting with the current patchwork regime.
Broadly, the proposed changes will mean that companies will be entitled to tax relief for the cost of acquiring intangible fixed assets, including goodwill as well as IP. Additionally, royalties – now a defined term not synonymous with the old interpretation – will be taxable or deductible on an accrual basis. The tax treatment of intangibles will therefore be generally aligned with their accounting treatment, and tax relief will be based on the income and expenses recognized in the financial accounts.
Under the new rules, distinctions between types of intangible assets will be of little relevance (accordingly, the wider term "intangible fixed asset" has been used below to incorporate all IP). Similarly, the question of whether income or expenses are deemed revenue or capital in nature will not be relevant, as the accounting treatment will determine the tax treatment.
Accounting for goodwill and intangible assets
As the proposed new rules seek to link the tax treatment of intangibles with their accounting treatment, it is important to understand the relevant UK accounting provisions. These are set out in the Financial Reporting Standard (FRS) 10, which is effective for accounting periods ending after December 22 1998.
For accounting purposes, intangibles are defined as non-financial fixed assets that do not have physical substance but which are identifiable and are controlled by the entity in question through custody or legal rights. In turn, a fixed asset is defined as one that is held, or intended to be held, for continuing use in the course of a company's activities; this is consistent with (and indeed the basis for) the above definition in the draft tax legislation. The draft tax legislation itself makes it clear that intangible assets that are internally generated can count as fixed and options to acquire or dispose of intangible fixed assets are themselves to be treated as intangible fixed assets.
The accounting provisions state that where IP is purchased separately from a business, it should be capitalized at cost. IP that is acquired as part of a business should be capitalized separately only if it can be reliably measured: if it cannot be reliably measured, it should be treated as goodwill. Internally generated goodwill should not be capitalized, although internally developed intangibles may be capitalized if they have a readily ascertainable market value.
When IP is capitalized separately, it should be amortized through the profit and loss account over its estimated economic life. There is, however, a presumption that the useful economic lives of purchased intangibles should not exceed 20 years from the date of acquisition. If the estimated economic life is indefinite, then no amortization is required for accounting purposes, assuming the intangible is expected to be capable of continued measurement through annual impairment reviews. Such annual impairment reviews will also be needed if the intangible is amortized over a period greater than 20 years.
Intangible assets with readily ascertainable market values may be revalued by reference to those values. However, impairment losses may be not be reversed if the increase in value has been generated internally.
What qualifies for tax relief?
The proposed new legislation will apply to all intangible assets. Intangible assets are defined in the draft legislation as having the same meaning as for accounting purposes (UK GAAP applies), and specifically includes IP (eg "any patent, trademark, registered design, copyright or design right"). It also includes rights under foreign laws, unregistered rights, licenses to use intangibles, and options over intangibles in certain cases. The provisions of the draft legislation then apply to this wide group of assets falling within the above definition of intangible fixed asset. Furthermore, goodwill, which for accounting purposes is the arithmetic difference between the fair value of separable assets acquired and the consideration paid for the overall business, is treated as an intangible fixed asset under these rules.
Critically, the new rules will only apply to assets that are created or acquired after the commencement date for new rules (which is expected to be some time in April 2002). The legislation attempts to prevent assets already held within the same economic family from being converted into newly acquired assets (in order to allow tax depreciation to be claimed where this would not have been possible under the old rules). The existing regime will continue to apply to all other IP, and companies will need to run parallel systems under the new and old rules for potentially many years to come.
However, the new rules will apply to royalties from the date of commencement, irrespective of whether the intangible asset creating the royalty was acquired before or after commencement date. A royalty under the new UK provisions is defined as "any payment in respect of the enjoyment or exercise of rights that are an intangible fixed asset". There is no longer any distinction between capital and revenue to consider.
Expenditure and relief
Tax relief will be based on the charges in the profit and loss account (ie expenses, amortization and impairment), including reversals of any accounting credits in previous years, in respect of the IP recognized in the financial accounts. Tax relief will also be available for abortive expenditure. In addition, the draft tax legislation contains provisions to limit the ability of a group of companies from amortizing an intangible fixed asset in its accounts over a shorter period than in the consolidated accounts in order to accelerate tax relief.
The main exception to the above accounts-based rule is that an irrevocable election can be made in respect of any intangible asset to claim a fixed rate tax deduction at 4% on a straight-line basis, irrespective of whether or not the asset is written down for accounting purposes. This is intended to give some tax relief for assets that have an indefinite economic life and are therefore are not amortized for accounting purposes.
Where an intangible asset is held for the purposes of a company's trade, the related expenditure will form part of the company's trading profits or losses and will be relievable as part of the trading result. For other business assets, any excess of expenditure over receipts will be available for relief against other taxable profits in the same period or for surrender to group members, and for carry-forward.
The expenditure that is classified as royalties under the above revised definition will be tax deductible as and when it is recognized for accounts purposes.
Taxation of income
Similarly, all income relating to intangibles and goodwill within the new regime will be taxable as it accrues in the accounts; most such income will fall within the new definition of royalties. Receipts arising in connection with intangible assets held for the purposes of the trade will be treated as trading profits, which can be relieved by brought-forward trading losses. For business assets that are not held for the purposes of a trade, any excess of receipts over expenses will be taxed as other income.
Taxation of disposals
When IP is sold, there will be a recapture of tax depreciation previously claimed. Where an asset is sold for more than its acquisition cost for tax purposes, the gain made over and above the cost of the intangible would also be taxable as income rather than capital. A sale at or below the carrying value for tax purposes (ie net of tax depreciation claimed to date) would allow additional tax depreciation to be claimed for the difference between the two figures.
A new reinvestment relief will be introduced to allow companies to defer profits on the disposal of intangible fixed assets within the regime where the proceeds are reinvested in assets also within the new regime. The reinvestment can be into any type of intangible fixed asset, to include goodwill as well as IP, and can also be made by another member of the same UK tax group. This replaces rollover relief, and is more limited than previously because gains may no longer be rolled over into assets such as land and buildings.
The cost of the new intangible fixed assets will be reduced by the profit reinvested, thereby reducing future tax depreciation on this asset and breaking the link between the tax and accounting treatment. The profit on disposal that may be deferred is limited to the excess of proceeds over original cost, such that the clawback of tax depreciation claimed to date will remain taxable. The time limit for reinvestment will be one year before and three years after the disposal, which is the same as under the current reinvestment rules for UK capital gains purposes.
It is also proposed to allow reinvestment into acquisitions of shares in a company which owns intangible fixed assets within the new regime, thereby aiming to achieve neutrality between acquisitions in share and asset form. In such cases, the profit reinvested will reduce the value of the intangibles held by the new subsidiary that can be depreciated for tax purposes. However, such neutrality will not apply to acquisitions of shares where the intangible fixed assets still fall within the old regime.
Sales of intangible fixed assets within a UK group will generally be tax neutral. If the sale or transfer is not effected at book value, the difference will only be recognized for tax purposes if the revaluation would have been required in any event under generally accepted accounting practice.
Transitional rules
The new regime will only apply to intangible fixed assets that are created or acquired from an unrelated party after commencement, (other than assets that were already in the new regime when acquired). The existing regime will continue to apply to all other IP (ie not in the old regime).
In terms of when an asset is deemed to be created or acquired for the purposes of the new rules, the general rule is that the relevant date is when the related expenditure is incurred. Incurred will, in turn, mean recognized for accounting purposes. However, where IP falls within the old rules and is acquired by an unrelated party so as to move it within the new rules, then the relevant date at which the expenditure is incurred will be by reference to the rules for determining the date of disposal under the old rules. For the disposal of IP falling within the capital gains rules, the relevant date will therefore be when beneficial ownership of the asset was transferred. This occurs, effectively, when all relevant contractual conditions for the sale have been fulfilled.
However, as detailed above, the new rules will apply to any royalties recognized in the accounts on or after commencement, regardless of when the asset to which the royalty relates to was created or acquired. At commencement, there will be a tax adjustment for royalties previously relieved or taxed on a paid or received basis, so as to move them over to an accruals basis. Where royalties have already been taxed (or relieved) prior to commencement, they will not be taxed (or relieved) again under the new rules.
For example, when a company has £1 million of unpaid royalties at the transition date relating to IP falling within the old rules, and has royalties of £2m recognized and paid in its first set of accounts under the new rules, then the total deduction for tax purposes that will be available in this period will be £3m, to incorporate the brought forward unrelieved amount.
TAX PLANNING
IP owned in the UK
When making an acquisition of a UK business there will more often be a clear advantage in purchasing the trade and assets, rather than shares, if the target business has IP of value that does not at the time of the acquisition attract tax depreciation as it is within the old UK rules. An acquisition of assets would allow the purchaser to obtain tax depreciation in respect of IP for which no tax relief may have otherwise been available.
However, in the UK, stamp duty is an issue for the purchaser to consider and it is charged at 4% on goodwill. Items of IP are normally exempt. Therefore, where the apportionment is mainly towards goodwill the benefits of depreciation will be largely outweighed by the stamp duty cost in the early years at least.
From a planning perspective, the interaction of the old and new rules create possibilities, if the seller of the IP is within the old rules, and the disposal is subject to capital gains treatment, capital losses or other relief from capital gains tax will often be available to shelter any gain from tax. Accordingly, the purchaser would often be able to obtain tax basis, and future tax depreciation, on the asset without a material tax charge arising to the seller.
As an extension of this, planning possibilities will be considered to try to generate a disposal under the old rules by one group company which can potentially be tax free, thereby allowing another group company to acquire the asset and obtain tax depreciation under the new rules. As detailed above, the transitional provisions prevent the new rules applying to assets acquired from within the same economic family, meaning that particular structuring is required to obtain the above benefit. Furthermore there is a general anti-avoidance rule that attacks transactions or arrangements that have a main purpose of securing relief not otherwise due.
Another relevant consideration for acquisitions of IP in the UK under the new rules would be to structure the acquisition so that clearly defined and identifiable IP is acquired. This would allow the IP to be treated separately from goodwill, meaning that the supportable economic life of the IP for accounting purposes is likely to be shorter. This would accelerate the timing of tax depreciation.
Exporting IP
Where IP is owned by a UK company, but exploited by other group companies outside the UK, there could be clear benefits if the IP could be transferred to an offshore company in a low-tax jurisdiction (for example Switzerland, Hungary or Ireland).
The first problem with this type of planning is the potential taxation arising in the UK on the disposal. The disposal value on a sale of IP to a related party outside of the UK would be deemed to be open market value. Under the existing rules, there may be potential to utilize, for example, capital losses within the group to shelter such a gain. However, transferring IP to an offshore group company will become more difficult under the new rules, as gains would be subject to income treatment, meaning that there would be less possibilities for relief, and that such relief could restrict potential future tax depreciation.
However, if IP has a low value at a particular point in time, with this value likely to increase in the future (for example as a result of future development of the IP, or reductions in current value for commercial reasons, as may be the case in certain industries at present), there may be an advantage in trying to export the IP before the increase in value arises. This would mean that the future income stream, which would be kept outside of UK taxation, would be significant in comparison. In addition, any gain would clearly be within the old rules, and therefore potentially attract more generous relief.
Another possibility for exporting IP from the UK would be to establish that existing arrangements within a group constituted a deemed cost sharing arrangement economically, meaning that non-UK parties already have ownership rights in the IP. This idea is, however, likely to be less relevant to the export of IP to a low-tax jurisdiction, as the low-tax jurisdiction is less likely to have contributed to the initial development of the IP.
The other key issue with regard to IP owned by a subsidiary of a UK parent in a low-tax jurisdiction would be the UK controlled foreign company (CFC) rules.
Where the low-tax offshore company receives royalty income in respect of the IP from related parties, this company would almost certainly, in the absence of other income in this company, be a CFC for UK purposes. There are planning possibilities to address this. These would include structuring the supply chain of the group such that the offshore company received income for the sale of products to third parties, rather than simply royalty income from related parties, ie the offshore company would itself be actively involved in the exploitation of the IP through to sale of the end product created from it. Another possibility would be to locate the IP, and therefore receive royalty income, in a trading entity in the offshore jurisdiction, such that the royalty income constituted less than 10% of the total income of this company.
However, the new UK rules should make companies reappraise the strategy of acquiring and exploiting IP offshore. The availability of depreciation and consistency between tax and accounting treatment reduce the disadvantage of owning IP in a UK company, whilst quite draconian anti-avoidance rules have made it increasingly difficult to maintain robust and effective offshore structures under a UK parent company. Each company's facts will determine whether a change of strategy is needed in the light of the new rules.
Shaun G Austin
Andersen
Four Brindleyplace
Birmingham B1 2HZ
UK
Tel: +44 121 626-4257
Fax: +44 121 633-3898
David Norton
Andersen
Abbots House
Abbey Street
Reading, Berkshire RG1 3BD
UK
Tel: +44 118 956 3602
Fax: +44 1189 508101
