Private ruling: Intangible asset depreciation and disposal
Date of advice: 25 June 2024
Published: 5 August 2024
Ruling period: Year ending 30 June 2023 | Year ending 30 June 2024
Date scheme commenced: 1 July 2022

Ruling: Q1: Does a balancing adjustment arise in accordance with Subdivision 40-D of the Income Tax Assessment Act 1997 (ITAA 1997) for Company A upon its granting of the Company A IP Licence to Company B? | A1: Yes. | Q2: If the answer to question one is 'Yes', in calculating the balancing adjustment, is the first element of the cost of the Company A IP Licence calculated in accordance with section 40-205 of the ITAA 1997? | A2: Yes. | Q3: If the answer to question two is 'Yes', following the split of the original cost of the Company A IP, will the proportion of the first element of the cost of the Company A IP that Company A continues to hold remain depreciable in accordance with section 40-25 of the ITAA 1997? | A3: Yes. | Q4: Is the Company A IP Licence fee received by Company A from Company B regarded as ordinary income or a royalty? | A4: No. | Q5: Is the Company C IP Licence fee paid by Company A to Company C considered a royalty and subject to withholding tax in accordance with section 128B of the Income Tax Assessment Tax 1936 (ITAA 1936)? | A5: No. | Q6: If the answer to question five is 'No', does the Company C IP Licence fee paid by Company A to Company C represent the cost of a depreciating asset in accordance with Subdivision 40-C of the ITAA 1997? | A6: Yes. | Q7: Does CGT event A1 occur on execution of the SSA? | A7: Yes.

Relevant facts and circumstances: 1. Company A is a company incorporated in Australia. 2. Company A has two Australian subsidiaries, Company D and Company E. Company D is a company incorporated in Australia and is a wholly-owned subsidiary of Company A. Company D owns the intellectual property of the group (the Company A IP). 3. Company E is a company incorporated in Australia and is a wholly-owned subsidiary of Company A. Company E is the Australian trading entity engaging with Australian customers. 4. Company A, Company D and Company E are all Australian residents for income tax purposes. 5. Company A and its wholly-owned Australian resident subsidiaries formed a tax consolidated group in 20XX with Company A being the head company. Company A IP 6. Company A IP includes various assets. Company A IP is used by Company E in operating the group's business in Australia, as well as overseas. 7. Company A IP is a depreciating asset for the purpose of Division 40 of the ITAA 1997. Company C IP 8. Company A acquired Company C in 20XX. Company C operates in a foreign country. 9. Company C provided business-to-business services. Post acquisition, Company C continued to own and develop its intellectual property assets (the Company C IP), and provide services to Company A's group and third parties. Foreign expansion 10. Post 20XX, Company A expanded into the foreign market. 11. To date, the foreign business operations have generated substantial operating losses that have contributed to a global retained loss position. Sale of the foreign business 12. Company A signed a sale agreement (SSA) in 20XX with an unrelated party Company F, in relation to the divestment of the foreign business, Company C and a licence to use and further develop the Company A IP. 13. In addition to the SSA, separate licence agreements document the terms of use and development for the Company A IP (the Company A IP Licence) and Company C IP (the Company C IP Licence) by the Company A group and Company F group post-transaction. 14. The licence agreements broadly provide for a world-wide, perpetual, royalty-free, non-exclusive and irrevocable (except on termination in specific circumstances) licence to the respective licensee to use, modify, develop and exploit the respective IP post-transaction.

Relevant legislative provisions: Copyright Act 1968 section 10 | Copyright Act 1968 section 31 | Income Tax Assessment Act 1936 section 128B | Income Tax Assessment Act 1997 section 6-5 | Income Tax Assessment Act 1997 subsection 6-5(1) | Income Tax Assessment Act 1997 subsection 6-10(1) | Income Tax Assessment Act 1997 section 10-5 | Income Tax Assessment Act 1997 section 15-20 | Income Tax Assessment Act 1997 subsection 15-20(1) | Income Tax Assessment Act 1997 Division 40 | Income Tax Assessment Act 1997 Subdivision 40-C | Income Tax Assessment Act 1997 Subdivision 40-D | Income Tax Assessment Act 1997 section 40-25 | Income Tax Assessment Act 1997 subsection 40-25(1) | Income Tax Assessment Act 1997 section 40-30 | Income Tax Assessment Act 1997 subsection 40-30(1) | Income Tax Assessment Act 1997 paragraph 40-30(1)(c) | Income Tax Assessment Act 1997 subsection 40-30(2) | Income Tax Assessment Act 1997 paragraph 40-30(2)(c) | Income Tax Assessment Act 1997 paragraph 40-30(2)(d) | Income Tax Assessment Act 1997 subsection 40-95(7) | Income Tax Assessment Act 1997 section 40-115 | Income Tax Assessment Act 1997 subsection 40-115(2) | Income Tax Assessment Act 1997 subsection 40-115(3) | Income Tax Assessment Act 1997 subsection 40-180(2) | Income Tax Assessment Act 1997 section 40-205 | Income Tax Assessment Act 1997 section 40-285 | Income Tax Assessment Act 1997 section 40-295 | Income Tax Assessment Act 1997 paragraph 40-295(1)(a) | Income Tax Assessment Act 1997 subsection 40-295(3) | Income Tax Assessment Act 1997 subsection 104-10(1) | Income Tax Assessment Act 1997 subsection 104-10(2) | Income Tax Assessment Act 1997 subsection 104-10(3) | Income Tax Assessment Act 1997 subsection 104-35(1) | Income Tax Assessment Act 1997 subsection 118-24(1) | Income Tax Assessment Act 1997 Division 328 | Income Tax Assessment Act 1997 section 701-1 | Income Tax Assessment Act 1997 subsection 995-1(1)

Reasons for decision: Detailed Reasoning - Detailed reasoning: Section 40-30 of the ITAA 1997 states: (1) A depreciating asset is an asset that has a limited *effective life and can reasonably be expected to decline in value over the time it is used, except: ... (c) an intangible asset, unless it is mentioned in subsection (2). (2) These intangible assets are depreciating assets if they are not * trading stock: ... (c) items of *intellectual property; (d) *in-house software; ... The terms 'intellectual property' and 'in-house software' are both defined in subsection 995-1(1) of the ITAA 1997. Subsection 995-1(1) defines 'intellectual property' as: ... an item of intellectual property consists of the rights (including equitable rights) that an entity has under a *Commonwealth law as: (a) the patentee, or a licensee, of a patent; or (b) the owner, or a licensee, of a registered design; or (c) the owner, or a licensee, of a copyright; or of equivalent rights under a *foreign law. Subsection 10(1) of the Copyright Act 1968 defines a 'literary work' as including: ... (a) a table, or compilation, expressed in words, figures or symbols; and (b) a computer program or compilation of computer programs. Subsection 10(1) of the Copyright Act 1968 further defines a 'computer program' as: ... a set of statements or instructions to be used directly or indirectly in a computer in order to bring about a certain result. Section 31 of the Copyright Act 1968 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 respect to a computer program, enter into a commercial rental arrangement in respect of it. Subsection 995-1(1) of the ITAA 1997 defines 'in-house software' as: ... computer software, or a *right to use computer software, that you acquire, develop or have another entity develop: (a) that is mainly for you to use in performing the functions for which the software was developed; and (b) for which you cannot deduct amounts under a provision of this Act outside Divisions 40 and 328. The term 'software' takes its ordinary meaning for the purposes of Divisions 40 and 328 and may include content. In-house software is software that is developed, by or for an entity, to be mainly for the entity to use within its organisation in performing the functions for which the computer software was developed. The Company A IP consists of assets developed internally and owned by Company D for use in the group's business. Company D holds this asset as an owner of copyright under the Copyright Act 1968 . The Company A IP relevantly satisfies the definitions of intellectual property and in-house software under paragraphs 40-30(2)(c) and 40-30(2)(d) of the ITAA 1997. Section 40-285 of the ITAA 1997 provides for an amount to be either included in the assessable income of a taxpayer or deducted by a taxpayer when a balancing adjustment event occurs. Section 40-295 of the ITAA 1997 states: (1) A balancing adjustment event occurs for a *depreciating asset if: (a) you stop *holding the asset; or ... (3) However, a balancing adjustment event does not occur for a *depreciating asset merely because you split it into 2 or more depreciating assets or you merge it with one or more other depreciating assets. Note: A balancing adjustment event will occur if you stop holding part of a depreciating asset. Section 40-115 of the ITAA 1997 states: ... (2) If you stop *holding part of a *depreciating asset, this Division applies as if, just before you stopped holding that part, you had split the original asset into the part you stopped holding and the rest of the original asset. (The rest of the original asset is then taken to be a different asset from the original asset.) ... (3) If you grant or assign an interest in an item of *intellectual property, subsection (2) applies to you as if you had stopped *holding part of the item. At the time that the Company A IP Licence agreement takes effect, Company A (by virtue of the single entity rule in section 701-1 of the ITAA 1997) is treated as having split the intellectual property and in-house software assets which are the subject of the Company A IP Licence. Company A then subsequently stops holding part of those assets in accordance with subsection 40-115(3) of the ITAA 1997. This results in a balancing adjustment event occurring for Company A in accordance with paragraph 40-295(1)(a) of the ITAA 1997. | Detailed Reasoning - Question 2: In calculating the balancing adjustment, the first element of the cost of the Company A IP Licence is calculated in accordance with section 40-205 of the ITAA 1997. | Detailed Reasoning - Detailed reasoning: Where a taxpayer holds an asset that is split into two or more assets, table item 1 of subsection 40-180(2) of the ITAA 1997 states that the cost for each of the split assets is the amount worked out under section 40-205 of the ITAA 1997. Section 40-205 of the ITAA 1997 provides that: If you split a *depreciating asset into separate assets as mentioned in section 40-115, the first element of the cost of each of the separate assets is a reasonable proportion of the sum of these amounts: (a) The *adjustable value of the original asset just before it was split; and (b) The amount you are taken to have paid under section 40-185 for any economic benefit involved in splitting the original asset. The first element of the cost of each of the split assets is calculated using a reasonable proportion of the adjustable value of the original Company A IP just before it was split. | Detailed Reasoning - Question 3: The first element of the cost of the Company A IP that Company A continues to hold remains depreciable under section 40-25 of the ITAA 1997. | Detailed Reasoning - Detailed reasoning: The cost of the Company A IP that Company A continues to hold, as determined under section 40-205 of the ITAA 1997, will be used in calculating a deduction for an amount equal to the decline in value in accordance with section 40-25 of the ITAA 1997. | Detailed Reasoning - Question 4: The Company A IP Licence fee received by Company A from Company B is not regarded as ordinary income or a royalty. | Detailed Reasoning - Detailed reasoning: Subsection 6-5(1) of the ITAA 1997 states: (1) Your assessable income includes income according to ordinary concepts, which is called ordinary income. Further, subsection 6-10(1) of the ITAA 1997 states: (1) 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. Other than the balancing adjustment provisions discussed above in question one, none of the other provisions listed in section 10-5 of the ITAA 1997 are relevant in the present circumstances. Therefore, the Company A IP Licence fee received by Company A will only be otherwise included in the assessable income of Company A if it is assessable as ordinary income under section 6-5 of the ITAA 1997. Accordingly, consideration needs to be given to whether the receipt of the Company A IP Licence fee is to be regarded as for the sale of the Company A IP or as a payment for the use of, or the right to use, the Company A IP. Receipts of a capital nature do not constitute income according to ordinary concepts. This issue was considered in Taxation Ruling TR 2008/7 Income tax: royalty withholding tax and the assignment of copyright where paragraph 14 states: The Commissioner accepts that an assignment of copyright amounts to an outright sale if: • it is for the full remaining life of the copyright; and • it extends geographically over an entire country or several entire countries; and • it is not limited as to the class of acts that the copyright assignee has the exclusive right to do; and • the amount and the timing of the payment or payments for the assignment are not dependent on the extent of exploitation of the copyright by the assignee. The form and substance of the Company A IP Licence is intended to achieve an outcome akin to ownership for Company B. The Company A IP Licence has the following features: • Under the Company A IP Licence, Company B has been provided a copy of the Company A IP and Company D has granted a world-wide, royalty-free, irrevocable, non-exclusive licence over the Company A IP. • It is for the full remaining life of the copyright (i.e. each party to the agreement owns their respective IP indefinitely). • Any modifications, improvements or development made by either Company D or Company B to their copy of the Company A IP is owned by that party outright. There are generally no limitations to what each party can do with the Company A IP from a development perspective. • The Company A IP Licence fee is based on the market value of the grant of the licence on an arm's length basis and is not dependent on the exploitation of the copyright (i.e. the payment is not structured by reference to the use of the Company A IP). On the basis of the above, the fee received by Company A under the Company A IP Licence is received on capital account and will not be assessable as ordinary income under section 6-5 of the ITAA 1997. For completeness, section 15-20 of the ITAA 1997 states, in relation to assessable income: (1) Your assessable income includes an amount that you receive as or by way of royalty within the ordinary meaning of "royalty" (disregarding the definition of royalty in subsection 995-1(1)) if the amount is not assessable as *ordinary income under section 6-5. ... The Commissioner summarises the key characteristics of a common law royalty in Taxation Ruling IT 2660 Income tax: definition of royalties which states at paragraph 10: 10. The key characteristics of a common law royalty (i.e. a royalty within the ordinary meaning of the term) were outlined by R. H. Woellner, T.J. Vella and R.S. Chippendale in Australian Taxation Law, CCH Australia Ltd, 1989 at pages 272- 273. They identified that a common law royalty will normally have all of the following features: (a) It is a payment made in return for the right to exercise a beneficial privilege or right (e.g. to remove minerals or natural resources such as timber, to use a copyright, or to produce a play) - McCauley v. F.C. of T. (1944) 69 CLR 235; 7 ATD 427; F.C. of T. v. Sherritt Gordon Mines Ltd (1977) 137 CLR 612; 77 ATC 4365; 7 ATR 726. Amongst other things, copyright can cover music, literary and artistic works, various forms of mechanical, electronic and biological knowledge, equipment and processes. Where, for example, the copyright is licensed to someone to manufacture and sell records, compact discs, books, prints of art works, motor vehicle engines, packaged computer software etc., for an amount based on the number of units produced or sold, the amount paid would be a royalty. (b) The payment is made to the person who owns the right to confer that beneficial privilege or right - Barrett v. F.C. of T. (1968) 118 CLR 666; Sherritt Gordon Mines Ltd; Case H9 76 ATC 39; 20 CTBR(NS) Case 64. However, the payment would still be a royalty if paid to another person or otherwise applied or dealt with at the direction of the owner. Moreover, payments for the use of the right that are made to a person who has been licensed or sub-licensed to deal with the right will also be regarded as royalty payments. (c) The consideration payable is determined on the basis of the amount of use made of the right acquired - McCauley; Stanton; Sherritt Gordon Mines; Case H9. (d) The consideration payable will usually be paid as and when the right acquired is exercised - McCauley; Stanton; Case H9. However, a lump sum payment will be a royalty where it is a pre-estimate or an after the event recognition of the amount of use made of the right acquired - I.R. Commissioners v. Longmans Green & Co Ltd (1932) 17 TC 272; Mills v. Jones (1929) 14 TC 769; Constantinesco v. R (1927) 11 TC 730. The Company A IP Licence permits Company B to perform acts and do things that would normally infringe upon the rights of Company D as the owner of various copyrights under the Copyright Act 1968 . The Company A IP Licence is perpetual and will only be terminated by mutual agreement in accordance with the Company A IP Licence agreement. The timing of the payment and the amount of the payment was not determined by the extent of the exploitation of the Company A IP. On this basis, the Company A IP Licence fee will not be treated as a royalty and accordingly is not assessable under section 15-20 of the ITAA 1997. Part 3-1 governs capital gains and capital losses. Subsection 104-35(1) of the ITAA 1997 states that CGT event D1 happens if you create a contractual right or other legal or equitable right in another entity. However, subsection 118-24(1) states: (1) A *capital gain or *capital loss you make from a *CGT event (that is also a *balancing adjustment event) that happens to a *depreciating asset is disregarded if the asset was: (a) An asset you *held; or ... where the decline in value of the asset was worked out under Division 40 (including that Division as it applies under Division 355), or the deduction for the asset was calculated under Division 328, or would have been if the asset had been used. For Company A, the execution of the Company A IP Licence agreement results in CGT event D1 happening, but per question one this also results in a balancing adjustment event as the Company A IP is an asset where the decline in value was worked out under Division 40. Accordingly, any capital gain or loss is disregarded. | Detailed Reasoning - Question 5: The Company C IP Licence fee paid by Company A to Company C is not a royalty and is not subject to withholding tax in accordance with section 128B of the ITAA 1936. | Detailed Reasoning - Detailed reasoning: The terms and conditions of the Company C IP Licence agreement are similar in form and substance to the Company A IP Licence agreement. We therefore consider that the detailed reasoning provided in question four also applies to the Company C IP Licence. Accordingly, the Company C IP Licence fee paid by Company A to Company C is capital in nature, not a royalty and not subject to royalty withholding tax under section 128B of the ITAA 1936. | Detailed Reasoning - Question 6: The Company C IP Licence fee paid by Company A to Company C represents the cost of a depreciating asset in accordance with Subdivision 40-C of the ITAA 1997. | Detailed Reasoning - Detailed reasoning: Subsection 40-25(1) of the ITAA 1997 provides that you can deduct an amount equal to the decline in value for an income year of a depreciating asset that you held for any time during the year. As per question one, a depreciating asset is defined in section 40-30 of the ITAA 1997 and excludes an intangible asset unless it is an item of intellectual property or in-house software. Upon execution of the Company C IP Licence agreement, Company A is treated as having acquired the Company C IP for market value consideration. The Company C IP is integrated with the existing technology assets of Company D and used in performing the functions for which the assets were developed (i.e. for internal use as part of ongoing business operations, and not for resale purposes). Accordingly, the Company C IP Licence will be treated as the cost of acquiring in-house software and depreciated over its effective life of five years per table item 8 of subsection 40-95(7) of the ITAA 1997. | Detailed Reasoning - Question 7: CGT event A1 occurred on execution of the SSA. | Detailed Reasoning - Detailed reasoning: CGT event A1 happens if you dispose a CGT asset under subsection 104-10(1) of the ITAA 1997. A CGT asset is disposed of if a change of ownership occurs, whether because of some act or event or by operation of law under subsection 104-10(2). The sale of shares by Company A constitutes CGT event A1 as the shares are a CGT asset. Subsection 104-10(3) of the ITAA 1997 provides that the time of the CGT event is when the contract for disposal is entered into. The meaning of the phrase 'entered into' is not defined in the legislation. However, under general law, the time when a contract is entered into is the time when the contract comes into existence. The existence of a contract occurs when a binding contract is formed upon the establishment of an agreement between parties (in the form of an offer and acceptance of that offer) where consideration passes, or will pass, from one party to another and the parties intend to be legally bound by this agreement. This timing may be affected where there are conditions precedent to the formation of a contract. Taxation Determination TD 2002/4 Income tax: capital gains: what is the first element of the cost base and reduced cost base of a share in a company you acquire in exchange for a share in another company in a takeover or merger? (at paragraph 5) relevantly draws a distinction between a condition which is precedent to the formation or existence of a contract and a condition which is precedent to performance of a contract. It provides that the non-fulfilment of a condition precedent to the formation of a contract prevents a binding contract from coming into existence, that is, no contractual rights enforceable by the parties to the contract are created unless and until the condition is fulfilled. This can be contrasted with a condition precedent to the obligation of a party to perform their part of the contract. That is, a binding contract exists which creates rights capable of enforcement, though the obligation of a party (or both parties) to perform their part of the contract depends on fulfilment of that condition and non-fulfilment of the condition entitles one or both parties to terminate the contract. The preference of the courts is to construe a contract as containing conditions precedent to performance, as opposed to formation. This is based on Perri v Coolangatta Investments Pty Ltd (1982) 149 CLR 537 where Mason J (although dissenting in the ultimate conclusion) stated at 552: Generally speaking the court will tend to favour that construction which leads to the conclusion that a particular stipulation is a condition precedent to performance as against that which leads to the conclusion that the stipulation is a condition precedent to the formation or existence of a contract. In most cases it is artificial to say, in the face of the details settled upon by the parties, that there is no binding contract unless the event in question happens. Instead, it is appropriate in conformity with the mutual intention of the parties to say that there is a binding contract which makes the stipulated event a condition precedent to the duty of one party, or perhaps of both parties, to perform. For these reasons the condition will not be construed as a condition precedent to the formation of a contract unless the contract read as a whole plainly compels this conclusion. It is clear from the words of Mason J that the language of a contract is critical when determining whether a condition in the contract is intended by the parties to be a condition precedent to formation or performance of the contract. It is likely that, if a contract can progress or be enforced without a condition being satisfied, the contract is already in existence and is valid and binding on the parties, and it will follow that the condition is a condition precedent to performance of some obligations under the contract, as opposed to the contract's formation. The condition discussed in Perri, which was held to be a condition precedent to the performance of the contract, was a condition that the parties could waive. While the SSA contained certain conditions, these were generally able to be waived by Company A, Company F or jointly as appropriate. It is apparent from the nature of these conditions and the conduct of Company A and Company F that both parties intended to enter into a binding agreement on the execution date, as opposed to only when the conditions were later satisfied. Accordingly, CGT event A1 occurs on the date of execution of the SSA.

Question 1: A balancing adjustment arises in accordance with Subdivision 40-D of the ITAA 1997 for Company A upon its granting of the Company A IP Licence to Company B.