Private ruling: Trading stock and tax cost setting amount of trading stock
Date of advice: 10 June 2021
Published: August 2021
Ruling period: 20XX
Date scheme commenced: 20XX

Ruling: Q1: Is the software, trading stock in accordance with section 70-10 of the Income Tax Assessment Act 1997 (ITAA 1997)? | A1: No | Q2: Is the additional software, trading stock in accordance with section 70-10 of the ITAA 1997? | A2: No Issue 2 Tax cost setting amount of trading stock | Q3: If the answer to Question(s) 1 and / or 2 is 'yes', is it appropriate to determine the tax cost setting amount of the software in accordance with section 705-40 of the ITAA 1997? | A3: Not applicable | Q4: If the answer to Question(s) 1 and/ or 2 is 'yes', for the purposes of applying section 70-35 of the ITAA 1997 to the software, for the income year ended XX Month 20XX, will the 'opening value' of the software be equal to the tax cost setting amount of the software, as determined under Division 705 of the ITAA 1997? | A4: Not applicable | Q5: If the answer to Question(s) 1 and/ or 2 is 'yes', for the purposes of applying paragraph 705-40(1)(a) of the ITAA 1997, will the total market value of the software be used for the purposes of determining the tax cost setting amount of the Software? | A5: Not applicable

Relevant facts and circumstances: Company A Company A is an Australian resident company and is the head company of a consolidated group (the Group). A member of the Group acquired 100% of the shares of Company B. The software Company B is in the business of developing and supplying software. Company B acquired and has continued to develop the software and the additional software. Company B also creates and updates documentation. Company B, or a related body corporate, owns or is the licensee of, all intellectual property rights, including amongst other things rights in respect of copyright, in the software, hosting arrangements and the documentation. Company B enters into agreements with clients, under which it grants a single non-exclusive, non-transferable licence to use the software and documentation for the purpose specified under the agreement. Clients use the software and additional software for administration and customer management purposes as provided for under the agreement. A client has the option of accessing the software by: • entering into a cloud hosting arrangement, whereby the software is hosted on a server • downloading and installing the software onsite as a desktop application. The additional software are online products that are hosted by Company B. The cloud version of the software and the additional software require an internet connection in order for a user to maintain access. A client who accesses the software as a desktop application, may use a single production copy of the software on its own server. A client may make a non-production copy of the software as permitted under the agreement. A client must not: • remove or obscure any copyright or trade mark notices on the software, hosting arrangement or the documentation • reproduce, copy, alter, modify, reverse engineer, disassemble, reverse assemble or reverse compile the software or a copy of the software • reproduce, copy, alter or modify all or any part of the documentation • supply a copy of the software or the documentation to any person. Company B retains all title and intellectual property rights in the software, hosting arrangement and documentation, including amongst other things any copyright. A client must not lease, sub-lease, lend, assign or transfer the software to third parties or assign or novate their rights under the agreement without approval. Under the terms of the agreement a client pays: • a licence fee on commencement of the agreement • a fee in respect of the first period under the agreement • a fee in respect of each 12 month period after the first period under the agreement. The agreement continues until terminated under the terms of the agreement. The agreement may be terminated immediately by Company B if the client fails to pay the fee for a particular period under the agreement. On termination of the agreement each licence granted under the agreement ceases and the client must: • cease using the software, hosting arrangement and documentation • return or destroy all copies of the software and documentation.


Reasons for decision: Summary: Legislative references in this Ruling are to provisions of the ITAA 1997, unless otherwise indicated. | Summary: The software and the additional software are not trading stock in accordance with section 70-10 as the rights granted under the agreement are not held for the purposes of sale or exchange. | Detailed Reasoning - Detailed reasoning: Subsection 70-10(1) defines 'trading stock' as including: (a) anything produced, manufactured or acquired that is held for purposes of manufacture, sale or exchange in the ordinary course of a *business; and (b) *live stock. ATO Interpretive Decision ATO ID 2009/97 Income tax: Definition of trading stock: meaning of 'for purposes of...exchange' states: In Federal Commissioner of Taxation v. Suttons Motors (Chullora) Wholesale Pty Ltd (1985) 157 CLR 277; 85 ATC 4398; (1985) 16 ATR 567, the majority of the High Court noted that the definition of trading stock builds on the ordinary meaning of the expression 'trading stock' as attributed to it by legal and commercial people. The majority noted that shares and land had both been held to be capable of being trading stock and stated: Its traditional and narrower denotation still lies at the centre of that meaning and is adequate for present purposes. That denotation is of goods held by a trader in such goods for sale or exchange in the ordinary course of his trade. When used in relation to "a business", as the term is used in the Act generally (see sec. 28) and in sec. 82D(1) in particular, that central meaning comprehends the goods held on hand in the business for the purpose of sale or exchange in the ordinary course of trade. The High Court in John v. Federal Commissioner of Taxation (1989) 166 CLR 417; 89 ATC 4101; (1989) 20 ATR 1 ( John ) stated that the definition of trading stock 'presupposes that the person by whom [goods] are produced, manufactured, acquired or purchased is or will be engaged in trade in those goods.' It is clear from the context in John and the other authorities that the trading activity to which the definition applies involves the passing of ownership of the things traded. In the Commissioner's view the terms 'sale' and 'exchange' in the expression 'sale or exchange in the ordinary course of a business' are complementary or correlative terms which are intended to cover trading activity in which ownership of the thing traded passes. In the usual case the consideration is money but in some cases something other than money may be received as consideration, as in a barter transaction. ATO ID 2009/97 goes on to conclude, in respect of the granting of rights, which are a chose in action, under a contract: Thus as the right is not capable of being sold or transferred, the right cannot be trading stock for the purposes of section 70-10 of the ITAA 1997. Taxation Ruling TR 94/14 Income Tax: application of Division 13 of Part III (international profit shifting) - some basic concepts underlying the operation of Division 13 and some circumstances in which section 136AD will be applied (TR 94/14), at paragraph 226 states: A chose in action means a thing recoverable by action as opposed to a thing which is enjoyed by possession (refer to Halsbury's Laws of England 4th ed, vol 6, para 1). This is the classical distinction between enforceable rights and property (in its ordinary sense). Examples of choses in action would be debts, contractual rights or rights to sue for breach of copyright, patent, negligence or trespass. The Macquarie Dictionary defines chose in action as: noun Law 1. an intangible form of property as debts, shares, intellectual property, contractual rights, etc., recoverable by an action. 2. a right which can be protected only by legal action. Further, the Macquarie Dictionary defines chattels as: plural noun 1. movable articles of property. 2. Law a. chattels personal, articles of property both movable and intangible, including debts, patents, copyrights, etc. A chose in action is a personal property right to an intangible object. In the case of Torkington v Magee [1902] 2 KB 427 a chose in action was defined as "personal rights of property which can only be claimed or enforced by action, and not taking physical possession". The main example of a chose in action is a debt. The Copyright Act 1968 (the Copyright Act) creates protection in respect of literary work which is in the form of personal property. Section 10 of the Copyright Actcontains the following relevant definitions: computer program means a set of statements or instructions to be used directly or indirectly in a computer in order to bring about a certain result. | Detailed Reasoning - copy:: (a) of a work-means a reproduction; ... copyright material means anything in which copyright subsists. exclusive licence means a licence in writing, signed by or on behalf of the owner or prospective owner of copyright, authorizing the client, to the exclusion of all other persons, to do an act that, by virtue of this Act, the owner of the copyright would, but for the licence, have the exclusive right to do, and exclusive client has a corresponding meaning. literary work includes: (a) a table, or compilation, expressed in words, figures or symbols; and (b) a computer program or compilation of computer programs. work means a literary, dramatic, musical or artistic work. Section 13 of the Copyright Act provides that the owner of a copyright has the exclusive right to authorise a person to do an act that is the exclusive right of the owner of the copyright. Section 31 of the Copyright Act provides that copyright in a literary or artistic work is, amongst other things, the exclusive right to reproduce it in a material form, to make an adaptation of the work and: • in the case of a computer program, to enter into a commercial rental arrangement in respect of the program (paragraph 31 (1)(d)) • paragraph (1)(d) does not extend to entry into a commercial rental arrangement in respect of a machine or device in which a computer program is embodied if the program is not able to be copied in the course of the ordinary use of the machine or device (subsection 31(3)) • the reference in subsection (3) to a device does not include a device of a kind ordinarily used to store computer programs (for example, a floppy disc, a device of the kind commonly known as a CD ROM, or an integrated circuit) (subsection 31(4)) • paragraph (1)(d) does not extend to entry into a commercial rental arrangement if the computer program is not the essential object of the rental (subsection 31(5)). Copyright will 'subsist in' an original literary work if: • it meets the conditions in subsection 32(1) or (2) of the Copyright Act (as applicable), or • if the work was not made or first published in Australia, it would meet those conditions if regulations made for the purposes of section 148 of the Copyright Act in Part 2 of the Copyright (International Protection) Regulations 1969 have the effect that subsection 32(1) or (2) of the Copyright Act (as applicable) applies to the work: - in the same way as it would in relation to an Australian work, and - as if the work were made or first published in Australia. The software and additional software, as defined in the agreement constitute, in whole or in part, one or more 'computer programs' for the purposes of the Copyright Act (as the software includes statements or instructions to be used directly or indirectly in a computer in order to bring about a certain result). Therefore, the software and the additional software are one or more items of 'literary work' for the purposes of the Copyright Act. The Copyright Act creates protection in respect of the software and the additional software which is in the form of personal property. In the current circumstances, the Commissioner is satisfied that Company A, as head company of the Group is taken to own the copyright in relation to the software and the additional software. In the current case, the copyright which subsists in the software and the additional software, represents rights which satisfy the definition of a CGT asset under section 108-5(1). Division 40 may apply to copyright, to the extent that it is not trading stock, under paragraph 40-30(2)(c) as it satisfied the definition of intellectual property in section 995-1. Company A contends that the rights which it grants under licence in respect of the software and the additional software on entering into the agreement: • are trading stock for the purposes of section 70-10 as Company B carries on a business of software licensing that earns revenue through licensing fees arising from the sale of licence agreements, or • should be regarded as dealing in copies of the software and the additional software. Company A is the owner of the copyright, being an intangible property right, in the software and the additional software. Company A authorises the use of the copyright in the software and the additional software by entering into the agreement with clients. In exchange, the client provides remuneration in the form of the licence fee and the fees paid with respect to each of the periods under the agreement. Company A does not distribute copies of the software or the additional software via a physical medium. Company A's software distribution model involves the provision of access to software by clients using the following channels: • the software is: - hosted on the cloud, on a server, or - downloaded and installed onsite as a desktop application by the Client • additional software is an online hosted product. The intellectual property rights which Company A owns in respect of the software and the additional software are classified as choses or "things in action" and it is some of these rights that are the subject of the agreement. Under the agreement the clients are granted certain limited rights, for example, a client may not use the software and the additional software in any way other than for administration of the business operated by the client, as specified in the agreement. The software and the additional software assists clients with other aspects of their business requirements. The rights granted to a client do not extend to reproducing, copying, altering, modifying, reverse engineering, disassembling, reverse assembling or reverse compiling the software and the additional software. The agreement does not allow a client to lease, sub-license or lend the software or the additional software to third parties or to assign or transfer their rights under the agreement. Section 70-10 provides that, for a thing to be trading stock it must be held for sale or exchange. The relevant question in this case is whether Company A holds the following for the purposes of sale or exchange in the ordinary course of its business: • software and additional software, and • the rights granted in respect of the use of the copyright in the software and the additional software under the terms and conditions of the Agreement. The agreement does not result in Company A disposing or otherwise transferring all of the rights relating to the copyright in the software or the additional software. Company A, as the licensor of the software and additional software, does not hold, produce or develop the software or the additional software for sale. Software that is distributed by way of cloud computing or digital download arrangements is not trading stock as it is not held for the purposes of sale or exchange. While intangible property can be trading stock, in a licence or relevant access arrangement under which software is distributed or made available for use, the software is not itself trading stock. This is because the software is not held for sale, sold or exchanged. On the same basis, in respect of the rights granted to use of the copyright in the software and the additional software under the terms and conditions of the agreement, the licence or relevant access arrangement under which software is distributed (in this context, the agreement) is also not itself trading stock. The arrangement entered into is such that access to the software and the additional software is provided under licence through online computing arrangements in the case of the cloud hosted version of the software and the additional software, or by way of digital download in the case of the desktop version of the software. While the agreement grants legal rights to the client which did not previously exist, the agreement does not involve the passing of legal rights as occurs in a sale or exchange transaction. That is, on execution of the agreement, Company A merely creates contractual rights in the relevant client for the term of the agreement, pursuant to which Company A permits a client to access and use the software and the additional software for the purposes of managing their business. The agreement, consisting of the granting of rights in respect of the use of copyright in the software and additional software, does not meet the definition of trading stock for the purposes of section 70-10, as the rights it creates are not capable of being held for sale, sold or transferred (see also, ATO ID 2009/97). | Detailed Reasoning - Conclusion: Therefore, the software, the additional software and the rights granted under the agreement are not trading stock as Company A does not hold the software, the additional software or the contractual rights created under the agreement for the purposes of sale or exchange. | Detailed Reasoning - Question 1: Not applicable as the software and the additional software are not trading stock for the purposes of section 70-10. | Detailed Reasoning - Question 2: Not applicable as the software and the additional software are not trading stock for the purposes of section 70-10. | Detailed Reasoning - Question 3: Not applicable as the software and the additional software are not trading stock for the purposes of section 70-10.