ATO ID 2009/3: Capital Allowances: business related costs - business transfer arrangement establishing rights to intellectual property
Date of decision: 26 November 2008
Year of income: Year ended 30 June 2008
Business line: Public Groups and International

Issue
Is some part of the price the taxpayer paid to acquire a business of franchising, capital expenditure on acquiring confidential information, trade secrets and know-how of the business for which a deduction may be allowable under section 40-880 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Decision
No. No part of the price the taxpayer paid to acquire a business of franchising is capital expenditure on acquiring confidential information, trade secrets and know-how of the business, because the character of the transaction and the nature of the assets acquired prescribe that the purchase price was paid to acquire the various rights that collectively constitute the business acquired. The whole of the capital expenditure incurred by the taxpayer was incurred on those rights and, therefore, is excluded from deduction under section 40-880 of the ITAA 1997 by the operation of paragraphs 40-880(5)(a) and 40-880(5)(f) of the ITAA 1997.

Facts
The taxpayer, a member of a corporate group, entered into an agreement with another member of the same corporate group to acquire a business that franchised to other members of the group the right to use a branded business format of undertaking a specific type of business operation. The existing franchisor's agreements granted the franchisees the exclusive right to use, within a specific territory, the collection of commercially recognised 'intellectual property' that enables use of a brand name and the business format that delivers the franchisee its custom. The 'intellectual property' is described in these agreements as intellectual property rights, both registered and unregistered, in respect of trade marks, business names, domain names, patents, designs, colour schemes, get-up, copyright, trade secrets, know-how, business processes, computer programs and confidential information. The business format incorporates a very detailed and specific set of operating procedures and processes, rules, policies and guidelines that prescribes all aspects of the operation of the business. These documents ensure that the franchisor's procedures etcetera, are effectively followed by the franchisee for the purpose of carrying on the franchisee's business. Upon acquisition of the business, the taxpayer carried on as franchisor in the same way. The franchise agreements impose strict controls over the manner and circumstances in which and by whom the various rights may be exercised. In addition, the employment contracts of the staff of franchisees are required to contain confidentiality clauses preventing use or disclosure of the documents and their content other than as authorised. The sale agreement also contained a number of conditions including: the vendor was required to assign to the taxpayer all of the existing franchise agreements; the directors of the vendor were required to enter restrictive covenants which prevented them from any future use of any information they hold in relation to the business; and any beneficial right to confidentiality under existing franchise and employment contracts of the vendor was assigned to the taxpayer. The sale agreement attributed part of the purchase price to that part of the business format described as confidential information, trade secrets and know-how.

Reasons for decision
Summary: All legislative references are to the ITAA 1997 unless otherwise stated. Section 40-880 provides a deduction over five income years for certain capital expenditure incurred in relation to a business. It is, therefore, a prerequisite requirement that capital expenditure be incurred for the provision to be capable of applying to the expenditure. The subject matter of the sale agreement in this case is enunciated as the acquisition of all the vendor's right, title and interest in all of the 'intellectual property' that collectively make up a branded business format. Confidential information, trade secrets and know-how are described in the sale agreement as a separately identifiable part of the business format and a part of the sale price was attributed to it. In determining whether a part of the purchase price was incurred to acquire the confidential information, trade secrets and know-how, it is crucial to ascertain precisely what was acquired. This, in turn, requires consideration of: (i) the nature of the business acquired; (ii) the nature and character of the assets acquired; and (iii) the nature of the particular transaction under which the business was acquired and its business assets delivered to the purchaser. The business of franchising in this case is carried on by granting to others the right to use, within a specified territory, the 'intellectual property' that enables use of a brand name and the business format that delivers the franchisee its custom. This 'intellectual property' is enunciated in the existing franchise agreements as trade marks, business names, domain names, patents, designs, colour schemes, get-up, copyright, trade secrets, know-how, business processes, computer programs and confidential information. The nature of the assets utilised in this business are all the 'intellectual property' rights held, maintained and developed to licence for a fee the brand name and associated business format. The particular nature of information is that, of itself, it can not in reality be sold ( Moriarty (Inspector of Taxes) v. Evans Medical Supplies Ltd [1957] 3 All ER 718). In considering the nature of dealings with information, it is necessary to consider both how the information is used and the nature of the transaction that purports to deal with it ( Rolls-Royce Ltd v. Jeffrey (Inspector of Taxes) [1962] 1 All ER 801). The confidential information, trade secrets and know-how described in the sale contract refers to the ideas and concepts upon which the business format was developed. Those ideas and concepts are, in effect, embedded and preserved in the documents and other subject matter which give expression to the business format (they may also be reflected in patents and registered designs). The taxpayer is the holder of the copyright in this subject matter providing it with the right to copy the subject matter to the exclusion of every other person. The taxpayer's copyright would be infringed by any person, other than the taxpayer, who makes a reproduction, adaptation or copy of a substantial part of the subject matter, without the licence of the taxpayer. The taxpayer gains effective control of the disclosure of the ideas and concepts through the assignment of the legal and equitable rights to confidentiality under the existing franchises and employment contracts and the creation of contractual rights to confidentiality under the restrictive covenants entered into by the directors of the vendor. Critically, it is the protection of copyrights, registered designs, patents and the right to maintain confidentiality which enable the taxpayer to carry on the business of deriving licences fees by granting exclusive use, within specific territories, of the branded business format that delivers custom to the franchisee. The fact that the sale agreement describes confidential information, trade secrets and know-how as a separate item within the business format and attributes a part of the purchase price to it does not determine the character of the transaction. The character of the transaction and the nature of the business acquired prescribe that the purchase price necessarily relates to the assets that comprise the various rights that enable the taxpayer to carry on the business. Consequently, the Commissioner considers that the purchase price, provided by the taxpayer as consideration for the acquisition of the business, is provided for all of the rights in relation to the trade marks, business names, domain names, patents, registered designs, copyrights, maintaining confidentiality and conducting the business. The price paid to acquire the business is, therefore, properly and wholly referable to those rights and not in any part referable to mere information which is neither real nor personal property. The rights held under copyrights, patents and registered designs are items of intellectual property for the purposes of the income tax law and are included in the definition of a depreciating asset under paragraph 40-30(2)(c). The remaining assets listed above are CGT assets pursuant to paragraph 108-5(1)(b). A deduction under section 40-880 is not allowed to the extent that the capital expenditure is taken into account in some way elsewhere in the income tax law. The capital expenditure incurred on acquiring the depreciating assets listed above forms part of the cost of the depreciating assets and is, therefore, excluded from deduction under section 40-880 by the operation of paragraph 40-880(5)(a). The expenditure incurred on acquiring the CGT assets listed above could be taken into account in working out the amount of a capital gain or capital loss from a CGT event because the expenditure forms part of the cost base of those assets. The expenditure will, therefore, be excluded from deduction under section 40-880 by the operation of paragraph 40-880(5)(f).

Legislative references: Income Tax Assessment Act 1997 paragraph 40-30(2)(c) section 40-880 paragraph 40-880(5)(a) paragraph 40-880(5)(f) paragraph 108-5(1)(b)
Case references: Moriarty (Inspector of Taxes) v. Evans Medical Supplies Ltd [1957] 3 All ER 718
Subject references: Blackhole expenditure Capital Allowances CoE Capital expenditure Cost of a depreciating asset Deduction for depreciating assets Deductions & expenses First element of cost Intellectual property rights Know how Uniform capital allowances system