Nigel Eastaway, senior tax consultant at WJB Chiltern plc, comments on the Revenue’s recent technical note
Published in the January 2001 issue of "Tax Adviser" On 8 November the Inland Revenue published a technical note succinctly entitled ‘Reform of the Taxation of Intellectual Property, Goodwill and Intangible Assets: The Next Stage’.
Before partners nurturing their goodwill and unincorporated owners of intellectual property start getting too excited it is worth pointing out that ‘the Government continues to take the view that the current reform should apply to corporation tax only’ (2.24). It will however continue to keep the income tax treatment of intangible assets under review. There has been an ongoing dialogue which started off with a consultation document published with the 1998 Budget entitled ‘Innovating for the Future: Investing in R & D’. This document included in Chapter 4 a summary of what the Revenue apparently thought was the tax treatment of R & D expenditure and intellectual property.
When it was pointed out to them that actually their summary was a gross over-simplification and the actual system in operation was a lot more complex than they apparently thought, discussions took place on what changes, if any, should be made to the current regime. This was followed in March 1999 by a technical note ‘Reform of the Taxation of Intellectual Property’ and a further note entitled ‘Research and Development, new tax incentives for small and medium-sized companies’.
The research and development discussions developed into Finance Act 2000, ss. 68 and 69 and Schs. 19-21 and the discussion on the reform of the taxation of intellectual property was widened to include any other intangibles such as goodwill, in a technical note published on 23 June 2000 entitled ‘Reform of the Taxation of Intellectual Property, Goodwill and Other Intangible Assets’.
The Chartered Institute of Taxation has, of course, responded to all these various documents and this is certainly not an area where we can complain of lack of consultation. That does not mean that all our suggestions have been taken on board, but at least if they are ignored they have been consciously ignored. I should point out that although I have been party to these discussions this article reflects my own views and not necessarily those of the Institute.
The current tax rules for intellectual property
The current situation with regard to the taxation of intangibles is that goodwill is usually treated as a capital asset. Patents are treated as a fixed asset eligible for capital allowances under the provisions of ICTA 1988, ss. 520 – 523 and 528, but with sales of patent rights normally being taxed as income under ICTA 1988, s.524 and 525, subject to spreading provisions and treatment of the income as earned income under ICTA 1988, s. 527 and 529 with relief for expenses in acquiring, maintaining or protecting the patent treated as a revenue expense under ICTA 1988, s. 526.
A royalty in connection with a UK patent is treated as an annual payment paid under deduction of tax and relieved as a charge on income under ICTA 1988, s. 348 (2) (a). This effectively applies a UK withholding tax on such royalties paid overseas.
Disposals of know-how are taxed, usually as income but in certain cases as capital under ICTA 1988, s. 530, and capital allowances are available on expenditure on know-how under the same section. Further provisions are made by ICTA 1988, s. 531-533 and it should be noted that reference to know-how is confined to industrial know-how by ICTA 1988 s. 533 (7). Know-how royalties are not normally annual payments unless they would be pure income profit of the recipient under the standard definition in Earl Howe v IRC (1919) 7 TC 289.
Copyrights and public lending rights are covered by ICTA 1988, s. 534-537, but these provisions deal with the taxation of the income and spreading, without giving rise to any relief for the purchaser. In most cases copyright will be bought by, or licensed to, publishers who normally write off the expenditure as a trading expense, even though a publisher’s back catalogue may be an asset of considerable value.
Where the copyright holder’s usual place of abode is outside the UK, ICTA 1988, s. 536 requires tax on royalties paid to be withheld at source, and accounted for to the Inland Revenue, except in the case of a cinematographic film or video recording or the soundtrack of such a film or recording. Withholding tax is also not applied to royalties paid to a professional author who lives abroad based on the premise that the source of the income is not the copyright, which arises under the law of the UK and is therefore a chose in action and UK property, but is a mere incident of the profession carried on by the author through the use of his brain, which is situated overseas and is therefore not UK source income. This was confirmed by the then Financial Secretary on 10 November 1969 (Hansard vols 791 Col 31).
The question of deduction of tax at source is considered in the current note in Chapter 5 and it is recognised that ‘under the current rules it can be difficult to decide whether particular income has a UK source’ and at 5.3 ‘many respondents (including the CIOT) said that deduction at source should be abolished either entirely or in cases where the recipient was resident in a country with which the UK had an appropriate double taxation treaty’. This has, however, not yet been accepted but it is acknowledged that respondents to the earlier documents did not want any extensions of the scope of payments subject to deduction at source.
So far as designs are concerned the current rules in ICTA 1988, s. 537A and 537B mostly follow the copyright rules.
There are no provisions in the Taxes Act relating to trademarks other than the allowability of expenses under ICTA 1988, s.83 so there is no withholding tax on payment of trademark royalties unless they fall within the definition of an annual payment.
No other form of intellectual property is specifically mentioned in the Taxes Act.
The Revenue seem to argue that it is necessary to have a withholding tax regime relating to royalties so that the withholding tax can be reduced to zero under a double taxation treaty i.e. that the UK have something to give up in return for foregoing its own withholding tax. It seems to me that this reasoning is flawed, in that Norway and the Netherlands, for example, which do not levy withholding tax on outgoing royalties, nevertheless negotiate zero withholding taxes with most treaty partners. The abolition of withholding taxes would obviously simplify the system substantially and, incidentally, help the UK to establish itself as a tax friendly place in which to do business.
It is however confirmed, at 5.7, that there is to be a limited reform of the deduction at source rules where the recipient is within the charge to UK corporation tax on the income. It is not clear whether UK patent royalties, which is the only category of intellectual property for which tax would be deductible in such circumstances, will cease to be a charge on income or merely that the tax will not require to be withheld on payments to another UK corporation or UK resident branch. This would mean that tax would still have to be deducted where the recipient was unincorporated or resident abroad. Hopefully any deduction at source should be confined to payments to non-residents.
Proposed taxation of intangibles
The current proposals are to treat as income receipts from the disposal of intangible fixed assets and to treat as a revenue expense amortisation of capital expenditure on such assets. In other words the tax treatment would follow the accounting treatment under FRS 10, allowing the provisions for amortisations in the accounts as deductible for tax purposes (3.3). The intangible assets referred to, start off with the definition in FRS 10 as ‘non-financial fixed assets that do not have physical substance but are identifiable and are controlled by the entity through custody or legal rights’. The revenue treatment of intangibles, such as publishers buying copyright treating it as a trading expense, will not be changed, and the accounts will have to follow normal accounting practice. There is a number of specific exclusions, including research and development expenditure dealt with under FA 2000, films, agricultural and fishing quotas, financial assets and oil and gas licences, where the existing rules will continue (2.12 to 2.17). However, tax relief will specifically be available in the case of internally generated intangibles written off to profit and loss account, even though the expenditure would on normal tax principles be treated as capital expenditure, but not within FRS 10 (for example internal software development). Relief will also be available for the incidental costs of acquiring intangible assets and abortive expenditure (2.18 -–2.22).
One of the more interesting areas in practice would be tax relief on the amortisation of purchased goodwill and conversely the treatment of the sale of goodwill as a revenue receipt, with the consequent loss of rollover relief under TCGA 1992, s. 152 – 159; as goodwill would be taken out of the definition of eligible assets under TCGA 1992, s. 155 Class 4 (2.8 – 2.11). The Revenue do accept (2.10) that such treatment would distort the market by making fiscally attractive the purchase of assets rather than the purchase of a company’s shares, with the potential double charge to tax on the vendor on the sale of assets by the company and again on the shares if the company is then liquidated. The solution in the USA is s. 338 of the US Internal Revenue Code which allows a share acquisition under certain circumstances to be treated for tax as if it were a disposal and acquisitions of the assets of the purchased company. There is no proposal to introduce such provisions into the UK at the moment, but the Government are prepared to consider representations on these lines which could ultimately have a significant effect on the structuring of take-overs. There is no intention to allow relief for the amortisation of goodwill arising on consolidation.
The technical note still shows traces of paranoia on the possibility of accounts being manipulated to improve the tax treatment, and in particular to ensure that there is broad symmetry on the two sides of any transaction, and although the Revenue believe that fair value accounting under FRS 7 will be helpful, they are still worried about lack of symmetry where the vendor is outside the charge to corporation tax, for example as a non-resident (3.6 – 3.13). The solution proposed in 3.9 is to have a ‘just and reasonable’ provision for the apportionment of the costs of bundled assets along the lines of existing capital allowances and capital gains provisions, e.g. CAA 1990, s. 150 and TCGA 1992, s. 52 (4). The Revenue are, however, worried about deferred or contingent consideration, which FRS 7 requires to be estimated at the fair value, because if both the purchaser and vendor took a pessimistic view, the seller would defer tax on the contingent consideration and the purchaser would claim amortisation on the increased amounts it thought payable. This must not be allowed to happen. (3.14, 3.15).
The technical note suggests an unhealthy interest on the part of the Government in taxing revaluation profits (3.17), on the grounds that amortisation of the uplift would have to be disallowed if revaluations were not taxed. I think few companies would wish to revalue if the tax consequences were to accelerate a tax charge on the increase in value while only being able to claim the amortisation of the remaining useful life of the asset. It seems unrealistic to expect companies to do this, and the consequence would be an undervaluation of assets shown on the balance sheet giving rise to potential take-overs by predators realising the hidden worth of the company, to the detriment of the shareholders. This cannot be sensible, and hopefully the Government will be persuaded that it is necessary to exclude revaluations, and any additional amortisation arising therefrom, under the new regime. The complication would be infinitely preferable to having to face either an unacceptable tax charge, for which no cash is available, or an undervaluation of assts and consequent difficulties with borrowing covenants, etc.
Inevitably there will be other anti-avoidance provisions although these are not yet spelt out (3.18). It is intended to ensure that intra-group transfers do not give rise either to a charge to tax or additional relief, and that avoidance opportunities are limited on transfers of businesses and degrouping (3.19 – 3.21). It is intended to ensure that the accounting policy adopted by the UK resident company will not be more conservative than that adopted in the group accounts, unless such treatment was required by some overseas GAAP (3.22 – 3.24). There is, as one would expect, some lengthy discussion on protecting the tax base in the face of aggressive write-offs, and the extent to which this can be countered by a challenge to the accounting basis adopted under SSAP2 and FRED 21, which is likely to be implemented shortly. The proposals seem to come down in favour of ensuring that the tax tribunal has the appropriate expertise to judge such issues (3.25 – 3.37).
It was argued that in relation to cross-border transactions, the transfer pricing and controlled foreign company rules ought to provide adequate protection against abuses in this area (3.38 – 3.44). What is proposed is that amortisation deductions claimed in respect of intangibles acquired cross-border from a connected party are ring fenced and deductible only against income derived from the exploitation of the same asset (3.41). There would also appear to be anti-avoidance provisions in respect of cross-border disposals to connected parties where the value of the intangible has been artificially reduced prior to disposal. The Revenue accept that there is a dislike of general anti-avoidance rules but feel the need for an ‘unallowable purpose’ test where the amortisation reliefs may have been engineered to increase the tax deduction, for example, by way of sale and leaseback (3.45, 3.46).
Chapter 4 deals with transitional and commencement rules. On the transitional provisions the Revenue seem rather ambivalent, 4.4 pointing out that ‘on the one hand the transition might bring everything into the new income regime and spread forward any resulting charges to mitigate the cashflow effects. On the other hand the transition might leave gains or losses accruing up to the transition date within the capital gains regime with income treatment thereafter’. The proposal on the first option is to allow a transitional period of six years and to bring the assets in at book value (4.5 – 4.13). Under the second option disposals after the commencement of the new regime will still be treated under the capital gains tax rules on existing assets, on accrued gains up to the date of commencement of the new regime, and post-commencement gains would be within the income regime. This would necessitate a deemed disposal at the commencement date for capital gains purposes which would be held over until the subsequent disposal. Although it is acknowledged that this is more complex it also provides a greater degree of fairness. Hopefully it will be accepted that, by the time the Revenue have incorporated all their anti-avoidance provisions into the new regime, it is going to be complex anyway and any additional complexity in making it fair as well would be minimal. There is also the point that if the rules are fair then the incentive for trying to exploit them is lessened. This option is explored in paras 4.14 to 4.19 but the suggestions in 4.18, as regards amortisation relief, is that they should be brought in at book value, with a subsequent adjustment to market value at commencement on a subsequent disposal, which seems fair enough. The alternative approach recognises that it would be more straightforward to allow amortisation relief for new acquisitions only, excluding intra-group transfers, which is pretty rough justice.
The technical note gives some indications of the reporting formats required on the acquisition or disposal of intangibles, and requested comments by 20 December 2000. We should expect draft clauses for further consultation in the new year with a view to including them in Finance Bill 2001.
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January 2001 by