PM Roach SM
Administrative Appeals Tribunal
P.M. Roach (Senior Member)
The applicant in this reference is a company which enjoys a special status in a particular field of primary production. Because, to identify the species in question would be to identify the applicant, instead of referring to the species as a flock of sheep, a pod of whales, a leap of leopards, or a charm of goldfinches, I shall refer to a ``bevy of beasts''.
2. For many years the applicant had been involved in the development of marketing of veterinary products. Inter alia it employed a staff of scientists. Some of the products it produced depended for their quality and marketability upon the development of a bevy of beasts untainted by certain identified diseases. After many years of effort, the applicant had succeeded in the development of such a bevy. The result was the product of application of considerable skills; substantial effort; and major expenditure as the scale of the experimental program increased and called for increasing capital expenditure. The result was that the applicant had one of the few bevies of its type in the world and the only one in Australia.
3. Others might have achieved the same, and indeed the way was open to them to do so. But there were obstacles in their path. Strict quarantine regulations prevented the importation of a disease-free bevy of beasts; development of such a bevy in the manner which had been followed by the applicant would involve the passage of many years, and even then would depend upon having the ``know-how'' of the applicant in order to achieve that standard in minimum time - something which meant that it would be necessary to deal with the applicant.
4. As a result, the applicant was very well placed vis-a-vis its competitors. But there was one major weakness in its position. If its pure bevy of beasts became diseased the evidence was that it would have to start again. Not only would that commit it to a long-term breeding program but it could easily have meant that it would have started in that several years behind its competitors. One alternative would have been for the applicant to have maintained a second bevy of beasts under conditions which would make it unlikely that both bevies could become diseased at the one time. But the problem with that course was said to be that the cost of maintaining environmental and all other conditions at the standard required would make the exercise quite uneconomic.
5. In the end the applicant decided to deal with one of its rivals: an international firm. The rival (``U-N-CO'') was allowed to purchase its own breeding stock but on terms which provided for the payment of a price. That price was returned as assessable income. Further, and most importantly, that bargain also contained mutual covenants. Should the bevy of either party become diseased, that party would have claim on the other for the acquisition of pure breeding stock as a matter of first priority.
6. But U-N-CO needed more than to establish ownership and possession of uncontaminated breeding stock. It needed to know how to maintain the purity of its bevy. That made it necessary for it to either follow the practice of the applicant and gain knowledge experimentally over many years or to acquire the information immediately. Once again, the latter course involved dealing with the applicant; and dealing with the applicant at a price.
7. So it was that the parties agreed that the applicant would ``from time to time supply to (the purchaser) such expertise and technical knowledge that (the applicant) shall possess in connection with...'' the valuable ``know-how'' it possessed. The price for sharing that knowledge was $31,400 all paid to
ATC 184the applicant in the year of income ended 30 June 1977 [sic]. In its return of income for that year the applicant disclosed in its profit and loss account ``Extraordinary Item - Sale of Expertise and Technical Knowledge $31,400''. In due course the Commissioner assessed the applicant on the basis that the moneys so received were not considered to constitute a capital receipt. The company objected and the Commissioner determined to disallow the objection. As a result, the applicant requested reference of its objection to a Taxation Board of Review for review.
8. That was on 8 December 1978: 10 years ago today.
9. After nearly eight years, the Commissioner carried out his statutory duty to comply with the applicant's request that the matter be referred for independent review. That was done on 29 October 1986 and the matter came for hearing before this Tribunal in November 1988.
10. In the period of more than a decade since the transaction giving rise to the dispute took place no similar transaction has ever been entered into by the applicant. Nor had any such transaction been entered into previously by the applicant.
11. The issues as joined revolve around questions as to whether, in the circumstances of the case, moneys received on the disposal of ``know-how'' constitute assessable income for the purposes of sec. 25(1), and secondly, by reason of the definition of royalty in sec. 6(1) of the Act, the moneys received constitute assessable income by force of sec. 26(f) of the Act. The latter question arises by reason of amendments to the sec. 6(1) definition of royalty enacted in 1976. The amended definition provides that:
``In this Act, unless the contrary intention appears -
- ... `royalty' or `royalties' includes any payment, whether periodical or not, and however described or computed, to the extent to which it is paid as consideration for -
- (a) the use of or the right to use, any copyright, patent, design or model, plan, secret formula or process, trade-mark, or other like property or right;
- (b) the use of, or the right to use, any industrial, commercial or scientific equipment;
- (c) the supply of scientific, technical, industrial or commercial knowledge or information;
- (d) the supply of any assistance that is ancillary and subsidiary to, and is furnished as a means of enabling the application or enjoyment of, any such property or right as is mentioned in paragraph (a), any such equipment as is mentioned in paragraph (b) or any such knowledge or information as is mentioned in paragraph (c); or
Section 26, so far as is material, provides:
``The assessable income of a taxpayer shall include -
- (f) any amount received as or by way of royalty other than an amount that -
- (i) but for the definition of `royalty' in sub-section (1) of section 6 would not be such an amount; and
- (ii) is not `income' within the ordinary meaning of that expression.''
12. I was advised that those provisions have not been the subject of any reported decision.
The royalty argument
13. ``Royalties'' can constitute assessable income simply because they possess the characteristic of income for the purposes of sec. 25(1) of the Income Tax Assessment Act 1936 (``the Act''). Alternatively, they may be assessable as income by force of sec. 26(f) of the Act. In so far as payments received constitute a reward to a taxpayer for permitting the use of his copyright or patent, or for permitting the exercise of rights to mine or fell timber, or for allowing fish, fowl or game to be taken so that the reward becomes a function of the exercise of that right, then in the ordinary sense of the term ``royalty'' the moneys will constitute assessable income.
14. Section 26(f) as it once stood as extending ``any amount received as or by way of royalty'' (at a time when there was no
ATC 185extended definition of ``royalty'') had the effect of making amounts received upon suffering the loss of trees by felling and removing, when the amount received was a function of the trees felled, a derivation of assessable income, despite the fact that, but for sec. 26(f), the transaction might have had the character of capital (
McCauley v. F.C. of T. (1944) 69 C.L.R. 235); but not if no nexus existed between the amount paid and the volume of trees taken (
Stanton v. F.C. of T. (1955) 92 C.L.R. 630). But by none of those standards is it proper to consider the payment made to this applicant a ``royalty''. It was a ``once only'' payment for parting with specialised knowledge and information.
15. But that circumstance does constitute the payment a royalty for the purposes of the Act because of the operation of the special definition of ``royalty'' now provided in sec. 6(1) of the Act. In my view, it is beyond argument that the amount was paid ``as consideration for... the supply of scientific, technical, industrial or commercial knowledge or information''. But that circumstance alone does not constitute the amount received as assessable income. Section 26(f) excludes from its embrace any amount that:
``(i) but for the definition of `royalty' in sub-section 6(1) would not be such an amount; and
(ii) is not `income' within the ordinary meaning of that expression.''
In the circumstances of this case I am satisfied that it is only by reason of the definition of ``royalty'' in subsec. 6(1) that the payment is to be regarded at all as a ``royalty''. That being so, the first of the exclusory tests is satisfied. What remains to be determined is whether the payment constituted ``income'' within the ordinary meaning of that expression. To determine whether or not the applicant satisfies the requirements of that provision necessitates that the question be addressed as to whether the payment constituted ``income'' for the purposes of sec. 25(1) of the Act.
The sec. 25(1) question
16. The argument as to the application of sec. 25(1) to the transaction largely revolved around the decisions of the House of Lords in
Evans Medical Supplies Limited v. Moriarty ((1957) 37 T.C. 540 at p. 573) and that in
Jeffrey v. Rolls Royce Limited ((1962) 40 T.C. 443 at p. 490). In both cases their Lordships recognised that the taxpayer had specialised knowledge (``know-how'') which, but for its sale, was not known to those to whom the information was to be communicated for a price. In the Rolls Royce case, by a series of transactions, the taxpayer entered into agreements for reward to make its ``know-how'' available to purchasers in several different countries for use exclusively in those countries by the purchasers. It was recognised that imparting that knowledge to others did not diminish the ``know-how'' possessed by the vendor, but it did diminish the value to the vendor of that knowledge. Their Lordships in the circumstances were unanimously of the view that, to quote Lord Radcliffe:
``It is clear that (the company) saw that, having the `know-how', it could derive profit from the manufacture of its engines, even by others, in parts of the world where it either could not or would not sell or manufacture them itself, provided only that it equipped those others with the requisite expertise. So it turned the `know-how' to account by undertaking, for reward, to impart it to the others in order to bring about this alternative form of manufacture.''
In the Court of Appeal, Donovan L.J. had described the problem in the following terms:
``... it does not matter a great deal by what name knowledge, skill and experience be called. They are clearly part of the capital equipment of a company such as the respondent, in much the same way as the same attributes are the capital equipment of an individual craftsman. They can be exploited in two ways. By their employment, articles can be produced and sold. Alternatively, or in addition, the knowledge, skill and experience can be imparted to others for reward. The great artist with his pupils is a familiar example. Similarly with a company such as the respondent. It can and does use its great experience, and the knowledge and skill which comes with it, to make and sell aero-engines. In addition it imparts these things to others for reward. Admittedly, it does this in the course of its trade, and the sole question here is whether that part of the reward consisting of a lump sum is a receipt which should be included in the revenue
ATC 186account when computing the company's taxable profits, or whether, on the other hand, the receipt should properly be credited to some capital account.''
17. But it is argued for the applicant that, unlike Rolls Royce, the present applicant did not embark upon a policy of selling his know-how; that it did not engage in multiple transactions; and that the one, isolated transaction in which it did engage was not in any way part of any ``trade'' of dealing with it know-how. It was argued that it was the decision in Evans Medical Supplies which would govern the outcome of this case. In that instance, there had been a ``once-only'' transaction in which the taxpayer company, which enjoyed a world-wide trade and reputation as manufacturing chemists and wholesale druggists, supplied all the ``know-how'' necessary for the establishment of a pharmaceutical factory to the Government of the Union of Burma. For that it received a lump sum. The case was argued on an ``all or nothing'' basis so that no consideration was given to the possibility of apportioning the payment so as ``to separate the value of a secret imparted to the Government and the value of the service rendered in imparting it'' (Viscount Simons at p. 581). A divided House, by majority, concluded that, in the special circumstances of the case, the ``sole question'' as argued, was to be resolved in favour of the taxpayer. In dissent, Lord Denning said:
``What, then, is the position of `know-how' for tax purposes? It is undoubtedly a revenue-producing asset. The possessor can use it to make things for sale, or he can teach it to others for reward. But he cannot sell it outright. It is rather like the `know-how' of a professional man. He can use it to earn fees from his clients, or he can teach it to pupils for reward, and so produce revenue. But he cannot sell it as a capital asset for a capital sum. He cannot sell his brains. So with a company which has special manufacturing skill and experience but has no secret processes. Its `know-how' is inseparable from the `know-how' of its staff and servants. It cannot prevent them using it any more than it can prevent them using their own brains. It cannot sell it as a capital asset. It can only use it or teach it. Even with a company which owns secret processes, the supply of `know-how' is not like the sale of goodwill or a secret process, for such a sale imports that the seller cannot thereafter avail himself of the special knowledge with which he has parted; and it may then rightly be regarded as the sale of a capital asset. But the supplier of `know-how' always remains entitled to use it himself, as was the case here.''
18. The latter words are relevant to the present reference because it is accepted that this is not a situation in which the applicant was being in any way compensated for forgoing any right to use its ``know-how'' or to practise its trade as it saw fit. It was entitled to use its ``know-how'' in its own operations, whether by way of ongoing breeding or by way of bargaining for the sale to others of the information it held. It lost nothing by the sale of ``know-how'' other than a diminution in the value of that ``know-how'' because it was no longer knowledge so exclusively held by the applicant as it had been before the sale. That is the nub of the matter for, as Viscount Simons said in Rolls Royce, in explaining his decision in Evans Medical Supplies in favour of the taxpayer:
``The facts in the earlier case were complicated, but the inference was there drawn that the capital sum in question was paid for the communication of secret processes to the Burmese Government with a resulting total loss to the company of its Burmese trade.''
There was no such loss for this applicant.
19. That being so, I am of opinion that the applicant fails to bring itself within the scope of the decision in Evans Medical Supplies (ante); and that the transaction - even though isolated - constituted assessable income for the reasons mentioned in Rolls Royce (ante). Accordingly, I conclude that the moneys received did constitute ``income' within the ordinary meaning of that expression''. That being so it is assessable income within the meaning of both sec. 25(1) and 26(f).
20. For the foregoing reasons the determination of the Commissioner upon the objection under review shall be affirmed.