Private ruling: Capital gains tax - capital proceeds
Date of advice: 9 June 2016
Published: July 2016
Ruling period: 30 June 2015
Date scheme commenced: 1 July 2014

Ruling: Q1: Are proceeds received by company A of capital nature and accordingly assessable under Part 3-1 of the Income Tax Assessment Act 1997 ? | A1: Yes.

Relevant facts and circumstances: Company A is in the business of software development. Company A has three main products, product A, product B and product C, that are provided to users on a subscription basis only. The company initially distributed product A through a distribution agreement with company B. The company distributed product B and product C directly to the clients. Company B approached the company offering to purchase product A. Company B, in negotiations advised that if the company did not accept, company B would prevent the company from accessing the company B database, effectively destroying product A as a saleable product to company B users. Prior to this offer, company A had no intention of selling but due to the commercial pressure decided that they would sell their product A client base to company B, grant company B a non-exclusive licence to the product A code base at the agreed value, and concentrate on building their income stream from product B and product C. Company A and company B entered into a Deed of Agreement in the relevant financial year. The purchase price per the Deed of Agreement was $X. The Deed of Agreement terminated the distribution agreement between company A and company, and resulted in the transfer of ownership of current product A clients and income streams to company B, along with a non-exclusive code-base licence. Company A continues to develop and offer subscriptions to product B and product C to company B clients. The Deed of Agreement states that upon the completion date, all existing agreements are hereby terminated by mutual consent. The Deed of Agreement states that company A grants to company B a perpetual, irrevocable (under any circumstances), worldwide, royalty free, license to use, copy, adapt, translate, sub-license or otherwise transfer, and in any other way exploit and commercialise product A. The Deed of Agreement assigns to company B, all right, title and interest in all intellectual property rights in the marks, free from any encumbrance of any type. The Deed of Agreement states that after the completion date all intellectual property rights in any adaptations, translation or modifications that are made to product A by company B, vest in or are assigned to the Company B. Company B has no obligation to provide copies of any such intellectual property rights to company A. While after the completion date all intellectual property rights in any adaptations, translations or other modifications that are made to product A by company A, vest in company A. Company A has no obligation to provide copies of any such intellectual property rights to company B. The Deed of Agreement states that company A shall not, and shall not permit any third party to, directly or indirectly, market, promote or license product A in competition with purchaser or use the source code to create any software or program that may be used in competition with product A.

Relevant legislative provisions: Income Tax Assessment Act 1997 section 6-5, | Income Tax Assessment Act 1997 section 6-10, | Income Tax Assessment Act 1997 section 10-5 and | Income Tax Assessment Act 1997 Part 3-1.

Reasons for decision: Summary: Subsection 6-5(1) of the Income Tax Assessment Act 1997 (ITAA 1997) states: Your assessable income includes income according to ordinary concepts, which is called ordinary income. Further, subsection 6-10(1) of the ITAA 1997 states: Your assessable income also includes some amounts that are not ordinary income. Note: These are included by provisions about assessable income. For a summary list of these provisions, see section 10-5. None of the provisions listed in section 10-5 of the ITAA 1997 are relevant in the present circumstances. Therefore the amount received by company A will not be assessable income under section 6-10. The amount received will only be included in the assessable income of company A if it is assessable income under section 6-5. Section 6-5 of the ITAA 1997 provides that your assessable income includes income according to ordinary concepts which is called ordinary income. The classic definition of ordinary income in Australian law was given in Scott v Commissioner of Taxation (1935) 35 SR (NSW) 215 by Jordan CJ: The word "income" is not a term of art, and what forms of receipts are comprehended within it, and what principles are to be applied to ascertain how much of those receipts ought to be treated as income must be determined in accordance with the ordinary concepts and usages of mankind, except in so far as the statute states or indicates an intention that receipts which are not income in ordinary parlance are to be treated as income, or that special rules are to be applied for arriving at the taxable amount of such receipts. The leading case on ordinary income is Eisner v Macomber 252 US 189 (1919). It was said in that case that: The fundamental relation of "capital" to "income" has been much discussed by economists, the former being likened to the tree or the land, the latter to the fruit or the crop; the former depicted as a reservoir supplied from springs, the latter as the outlet stream, to be measured by its flow during a period of time. …Here we have the essential matter: not a gain accruing to capital, not a growth or increment of value in the investment; but a gain, a profit, something of exchangeable value proceeding from the property, severed from the capital however invested or employed, and coming in, being "derived" that is, received or drawn by the recipient (the taxpayer) for his separate use, benefit and disposal; …that is income derived from property. Nothing else answers the description. In GP International Pipecoaters Pty Ltd v Federal Commissioner of Taxation (1990) 170 CLR 124 the High Court of Australia held that whether a receipt is income or capital depends on its objective character in the hands of the recipient. It was further stated at page 138 that: To determine whether a receipt is of an income or of a capital nature, various factors may be relevant. Sometimes, the character of receipts will be revealed most clearly by their periodicity, regularity or recurrence; sometimes, by the character of a right or thing disposed of in exchange for the receipt; sometimes, by the scope of the transaction, venture or business in or by reason of which money is received and by the recipient's purpose in engaging in the transaction, venture or business. Receipts of a capital nature do not constitute income according to ordinary concepts, whether or not incurred in carrying on a business. In your circumstances the Deed of Agreement states that that company A grants to company B a perpetual, irrevocable (under any circumstances), worldwide, royalty free, license to use, copy, adapt, translate, sub-license or otherwise transfer, and in any other way exploit and commercialise product A. Furthermore the Deed of Agreement assigns to company B, all right, title and interest in all intellectual property rights in the marks, free from any encumbrance of any type. Therefore the licence obtained by company B under the Deed of Agreement will permit company B to perform acts and do things that would normally infringe upon the rights of company A as the owner of various copyrights under the Copyright Act 1968 . However under of the Deed of Agreement, after the completion date all intellectual property rights in any adaptations, translation or modifications that are made to product A by company B, vest in or are assigned to company B. Company B has no obligation to provide copies of any such intellectual property rights to company A. While after the completion date all intellectual property rights in any adaptations, translations or other modifications that are made to product A by company A, vest in company A. Company A has no obligation to provide copies of any such intellectual property rights to company B. Furthermore there is also a restraint on company A under the agreement which states that it shall not, and shall not permit any third party to, directly or indirectly, market, promote or license product A in competition with purchaser or use the source code to create any software or program that may be used in competition with product A. The nature of a payment for a licence has been the subject of some judicial consideration in the United Kingdom and Australia. Lord Denning provided a good description of how amounts received for the granting of a licence are generally viewed in Murray (Inspector of Taxes) v Imperial Chemical Industries Ltd [1967] 2 ALL ER 980 ( Imperial ). Lord Denning in Imperial at 982-983 stated in the context of an assignment of patent rights: I see no difference in this regard between an assignment of patent rights and the grant of an exclusive licence for the period of the patent. It is the disposal of a capital asset. But this does not determine the quality of the money received. A man may dispose of a capital asset outright for a lump sum, which is then a capital receipt. Or he may dispose of it in return for an annuity, in which case the annual payments are revenue receipts. Or he may dispose of it in part for one and in part for the other. Each case must depend on its own circumstances; but it seems to me fairly clear that if and in so far as a man disposes of patent rights outright (viz, by an assignment of his patent, or by the grant of an exclusive licence) and receives in return royalties calculated by reference to the actual user, the royalties are clearly revenue receipts. If and in so far as he disposes of them for annual payments over the period, which can fairly be regarded as compensation for the user during the period, then those also are revenue receipts (such as the payment of £2,500 a year over ten years in Inland Revenue Comrs v British Salmson Aero Engines Ltd , and, of course, the royalties of £10,000 a year in the present case). If and in so far as he disposes of the patent rights outright for a lump sum , which is arrived at by reference to some anticipated quantum of user , it will normally be income in the hands of the recipient (see the judgment of Lord Greene MR in Nethersole v Withers (Inspector of Taxes) ([1946] 1 All ER 711 at p 716; 28 Tax Cas, 501 at p 512.), approved by Viscount Simon in the House of Lords ([1948] 1 All ER 400 at p 403; 28 Tax Cas at p 518.)). If and in so far, however, as he disposes of them outright for a lump sum which has no reference to anticipated user, it will normally be capital (such as the payment of £25,000 in the British Salmson case ). It is different when a man does not dispose of his patent rights, but retains them and grants a non-exclusive licence. He does not then dispose of a capital asset. He retains the asset and he uses it to bring in money for him. A lump sum may in those cases be a revenue receipt (see Rustproof Metal Window Co Ltd v Inland Revenue Comrs , per Lord Greene MR ([1947] 2 All ER 454 at p 459; 29 Tax Cas 243 at p 270.), who emphasised that it was a non-exclusive licence there). Similarly a lump sum for "know-how" may be a revenue receipt. The capital asset remains with the owner. All he does is to put it to use. The observations of Lord Denning in Murray were referred to in Kwikspan Purlin System Pty Ltd v Commissioner of Taxation (Cth) (1984) 71 FLR 154 ( Kwikspan ) by Campbell J at 159. In Kwikspan it was determined that certain lump sum receipts received for the grant of exclusive licences to use a patented invention in different parts of Australia were not part of a profit-making undertaking or scheme and therefore were capital in nature. Furthermore as the company in question was not in the business of dealing in patents, the receipts were not on income account. Under the Deed of Agreement company B will pay the purchase price for the licence in one single amount to company A. Under the Deed of Agreement, company B acknowledges that it has the right to use the intellectual property, but company B remains free to exploit the same intellectual property. However company A is restricted from marketing, promoting or licensing product A in competition with company B and is unable use the source code to create any software program that may be used in competition with product A. Furthermore the licence obtained by company B is perpetual and irrevocable. The purchase price for the licence was based on calculating the present value of the current income stream received from product A. Company A is in the business of developing software. Company A is not in the business of dealing in copyrights. On the basis of the above it is determined that the purchase price for the licence paid by company B to company A under the Deed of Agreement is capital in nature and accordingly will be assessable under Part 3-1 of the ITAA 1997.