Case U33

Members:
CJ Bannon QC

Tribunal:
Administrative Appeals Tribunal

Decision date: 3 February 1987.

---

C.J. Bannon Q.C. (Deputy President)

In these proceedings the applicant ("the taxpayer"), a private company, seeks a review of an assessment dated 30 October 1978 made pursuant to the Income Tax Assessment Act 1936 (Cth) ("the Act"), assessing its income tax liability for the year ending 30 June 1977 to be $1,799.52. By notice of objection dated 30 October 1978, the taxpayer put forward three grounds on which it objected to the assessment. The essential ground is that the sum of $4,009 received by it from a partnership ("Y") was not "as or by way of royalty" and was a capital receipt and so was not assessable income of the company.

The taxpayer, it appears, was formed as a repository for industrial property rights. Y is a partnership consisting of the taxpayer and another company ("X") which holds its interests in the partnership on behalf of two family trusts.

By a written agreement (Exhibit B3) dated 1 June 1976 between the taxpayer and X, together trading as Y, on the one hand, and Product Specialties Inc. of the State of Delaware, United States of America ("U.S.A.") on the other, Y licensed Product Specialties Inc. as an exclusive licensee "to make, have made, use and sell" lawn edgers in accordance with the invention claimed in Y's United States, Letters Patent No. 3,943,998 and as a non-exclusive licensee "to make or have made" the said lawn edgers anywhere for sale in the U.S.A. The agreement is expressed to continue, unless previously terminated for default or by notice, for the full term of the Letters Patent and any extension thereof (cl. 15). The agreement does not expressly nominate the proper law of the contract although the licensor has an address in New South Wales. It may be surmised that the contract was drafted by or on behalf of the licensor, but this is only a speculation and it would not be safe to apply the contra proferentem rule to it. Clauses 2, 3 and 7 are in the following terms:

"2. LICENSEE agrees to pay LICENSOR a royalty of fifteen cents U.S. currency ($0.15) for each of the LAWN EDGERS made or sold by LICENSEE in the United States of America which would, except for the license granted herein, infringe said PATENT.

3. Upon execution of this Agreement by both parties, LICENSEE shall pay LICENSOR ten thousand dollars U.S. currency ($10,000) as a nonrefundable advance against the royalties provided for in Paragraph 2. Royalties payable under Paragraph 6 may be credited against said advance throughout the term of this Agreement. The payments provided for in Paragraph 7 for maintaining this license exclusive may also be credited against said advance if LICENSEE in its sole discretion elects to do so.

...

7. In case the royalties accrued and paid hereunder do not aggregate a minimum of two thousand dollars ($2,000) for the year ending May 31, 1977, and four thousand

---

ATC 252

dollars ($4,000) for each succeeding year during the life of this Agreement, LICENSEE shall, if it wishes to maintain the exclusivity of the license granted herein, within sixty (60) days of the end of each such year, pay LICENSOR the difference between the actual royalties paid and such minimum sum. The only effect upon this Agreement of LICENSEE's failing to pay such minimum sum is that exclusive license granted herein shall become a nonexclusive license."

By letter dated 19 July 1977, from Sunbeam Outdoor Company, a division of Sunbeam Corporation to Y (Exhibit B4), it was made clear that the licensee corporation had been dissolved and that it was not economic to manufacture the edge cutter (known as the "Zippy Lawn Edger") in the U.S.A. It appears from the letter that none was manufactured in the U.S.A. and it appeared doubtful that any imported edge cutters were in fact sold.

The sum of $US10,000 mentioned in cl. 3 of the agreement (Exhibit B3) was the equivalent of $A8,020 received by the partnership in August 1976. The money in dispute on the assessment is $A4,009 being the share of the $A8,020 received by the taxpayer in accordance with partnership distribution. The taxpayer submits that the $A4,009 was not received "as or by way of royalty" and was a capital payment. The respondent contends that the amount in question does fall within the meaning of "royalty" and is "income" within the ordinary meaning of that expression and so is correctly included as assessable income under sec. 26(f) of the Act.

In 1977 when the assessment was made sec. 26(f) of the Act provided:

"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."

In determining whether the $A4,009 in question is assessable income under sec. 26(f) of the Act several questions must be answered. Firstly, it must be ascertained whether the sum of $A4,009 received by the taxpayer was received "as or by way of royalty".

When considering the meaning of "royalty" for the purposes of sec. 26(f) it is necessary to look to both the general law meaning of royalty and the definition of "royalty" provided in sec. 6(1) of the Act. If the payment is characterised as a royalty according to the general law meaning then it will be assessable under sec. 26(f) regardless of whether it is of a capital or income nature. Whereas if its characterisation as a royalty arises solely by operation of the definition of royalty in sec. 6(1) it must be of an income nature for sec. 26(f) to apply.

Thus if the payment does not fall within the meaning of "royalty" either at general law or under the sec. 6(1) definition then sec. 26(f) cannot be applied. Alternatively, if it is a "royalty" within the sec. 6(1) definition and is of a capital nature, then it also will not be caught by sec. 26(f) and so is not assessable income of the taxpayer.

Turning now to the general law meaning of the term "royalty", in
McCauley v. F.C. of T. (1944) 69 C.L.R. 235, Latham C.J. saw royalties as payments made for the right to utilise the property of another, where the payments vary according to the extent to which the right is exercised. In that case the payments in question were held to be royalties because they were calculated by reference to the quantity of timber cut and removed.

In the later case of
Stanton v. F.C. of T. (1955) 92 C.L.R. 630 at p. 639 the High Court drew a distinction between the facts before it and those in McCauley's case pointing out that in the latter case the amount payable was "in respect of the timber cut and it was calculated thereon by reference to the quantity cut", whereas the agreement in Stanton's case made it clear that the price was payable whether the right to take the timber was exercised or not; that is, it was fixed regardless of the quantity of timber cut and removed. As such the payments did not satisfy what the High Court saw to be the essential requirement that they "be made in respect of the particular exercise of the right to take the substance and therefore should be calculated either in respect of the quantity or value taken or the occasions upon which the right is exercised" (Stanton at p. 642).

---

ATC 253

In
F.C. of T. v. Sherritt Gordon Mines Ltd. 77 ATC 4365 at p. 4372; (1977) 137 C.L.R. 612 at p. 626, Mason J. referred to and followed the Full Court decision in Stanton stating that in that case the Court had "made it clear that it is of the essence of a royalty that the payments should be made in consideration of the grant of a right, that they should be made in respect of particular exercises of the right and therefore should be calculated in the manner stated".

In my opinion the lump sum payment in question in this application cannot be said to fall within the general meaning of "royalty" as outlined above. The payment under cl. 3 is not made in respect of the particular exercise of the invention and is not calculated by any reference to the occasions upon which the right is exercised. The reference to the royalty rate is simply a statement that no royalties are payable until units which would otherwise carry royalty, have been made or sold in excess of a quantity which at the royalty rate set out in cl. 2 of the agreement, would have otherwise entitled the licensor to $US10,000. The money is not refundable, and at the licensee's option payments made pursuant to cl. 7 may be credited towards the grant of future exclusive licences.

Considerable difficulty would arise if the lump sum were to be treated as in respect of royalties in the first instance, because under cl. 7 it can be turned into a mixed fund at the licensee's option and the precise mixture is not evident until the exercise of each option contained therein. (See
Texas Co. (Australasia) Ltd. v. F.C. of T. (1940) 63 C.L.R. 382 at p. 468.)

It is true that the agreement in cl. 3 characterises the lump sum as being an advance payment in respect of royalties, but such characterisation is not conclusive as to the true construction of the agreement. (See
Radaich v. Smith (1956) 101 C.L.R. 209 at p. 214;
Chaplin v. Leslie Frewin (Publishers) Ltd. (1966) Ch. 71 at p. 94;
Cliffs International Inc. v. F.C. of T. 79 ATC 4059 at p. 4064; (1979) 142 C.L.R. 140 at p. 148.)

I have been referred to but do not accept the proposition that a sum expressed to be an advance upon royalties is necessarily in respect of royalties. In this respect reference has been made to Case 103,
11 C.T.B.R. 308.

It should also be noted that the fact that the payment made under cl. 3 of the agreement was a lump sum payment is not in any way decisive to show that it was not paid in respect of royalties. As Finlay J. pointed out in
I.R. Commrs v. Longmans Green & Co. Ltd. (1932) 17 T.C. 272 at p. 284:

"... it does not matter whether you have got a sum paid every year or a sum paid every three years, or even a sum paid once and for all; you have got to look at the substance of the thing and arrive at a conclusion as to whether in truth the sum was paid in respect of royalties."

In this application, although the payment made under cl. 3 of the agreement was a lump sum and although it was expressed to be an advance against royalties, the true construction of cl. 3 is, in my opinion, that the payment was made in consideration of the right of the licensee to "make, have made, use and sell" the lawn edgers and was not calculated by any reference to the extent to or occasions on which the right would be exercised. Therefore it is not a payment which can be said to fall within the general law meaning of "royalty".

The next question which must be answered in this review is whether the payment made under cl. 3 of the agreement falls within the statutory definition of "royalty".

Section 6(1) of the Act amongst other things defines "royalty", so far as is relevant, as follows:

"`royalty' or `royalties' includes any amount paid or credited, however described or computed, and whether the payment or credit is periodical or not, to the extent to which it is paid or credited, as the case may be, 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;"

This definition is very wide and covers certain payments which would not fall within the ordinary meaning of the term "royalty". The lump sum payment made under cl. 3, being a payment made as consideration for the right to use a patent, would appear to be caught by the extended meaning of royalty in sec. 6(1). Since the payment is classified as a royalty solely by way of the sec. 6(1) definition

---

ATC 254

then it is assessable under sec. 26(f) of the Act only if it is "income" within the ordinary meaning of that expression.

Thus it becomes necessary to consider whether the payment is of an income or a capital nature. The taxpayer claims that the $A4,009 is capital and the respondent contends that it is income.

In
Nethersole v. Withers (H.M. Inspector of Taxes) (1946) 1 All E.R. 711 at p. 716, Lord Greene M.R. referred to
I.R. Commrs v. British Salmson Aero Engines Ltd (1938) 2 K.B. 482 and said:

"This decision is a clear authority, so far as this court is concerned, that a lump sum payment received for the grant of a patent licence for a term of years may be a capital and not a revenue receipt; whether or not it is so must depend on any particular facts which, in the particular case, may throw light upon its real character, including, of course, the terms of the agreement under which the licence is granted. If the lump sum is arrived at by reference to some anticipated quantum of user it will, we think, normally be income in the hands of the recipient. If it is not, and if there is nothing else in the case which points to an income character, it must, in our opinion, be regarded as capital."

Both Viscount Simon in
Withers (H.M. Inspector of Taxes) v. Nethersole (1948) 1 All E.R. 400 at p. 403 and Davies L.J. in
Murray (Inspector of Taxes) v. Imperial Chemical Industries Ltd. (1967) Ch. 1038 at p. 1053 adopted the above observations of Lord Greene M.R. The observation was also noted by Campbell J., as he then was in
Kwikspan Purlin System Pty. Ltd. v. F.C. of T. 84 ATC 4282 at p. 4286; (1984) 15 A.T.R. 531 at p. 536.

In the Imperial Chemical Industries Ltd. case, Lord Denning M.R. said (at p. 1052):

"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 (for example, 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 10 years in
Inland Revenue Commissioners v. British Salmson Aero Engines Ltd. (1938) 2 K.B. 482; 54 T.L.R. 904; (1938) 3 All E.R. 283; 22 T.C. 29, C.A. 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 M.R. in Withers v. Nethersole (1946) 1 All E.R. 711, 716; 28 T.C. 501, C.A., approved by Lord Simon (1948) 64 T.L.R. 157, 159; (1948) 1 All E.R. 400; 28 T.C. 501, H.L. in the House of Lords). But if, and in so far 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 [1938] 2 K.B. 482 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 Commissioner, (1947) 2 All E.R. 454, 459; 29 T.C. 243, C.A., per Lord Greene M.R., 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.

Applying these criteria, in the present case it is quite clear that the royalties for the master C.P.A. patents and the royalties for the ancillary I.C.I. patents were revenue receipts. That is admitted. So far as the lump sum is concerned, I regard it as a

---

ATC 255

capital receipt, even though it is payable by instalments. I am influenced by the fact: (1) that it is part payment for an exclusive licence, which is a capital asset; (2) that it is payable in any event irrespective of whether there is any user under the licence. Even if the licensee were not to use the patents at all, this sum would still be payable; (3) that it is agreed to be a capital sum payable by instalments; and not as an annuity or a series of annual payments."

In this respect regard should be had also to the Privy Council's advice in
B.P. Australia Ltd. v. F.C. of T. (1966) A.C. 224 especially at p. 261.

The decision in the Imperial Chemical Industries Ltd. case was followed in Queensland by Campbell J. in the Kwikspan case (supra). The question in that case was whether lump sum payments made in consideration of the grant of an exclusive licence to manufacture and sell a multi-holed purlin and girt system should be regarded as a capital or income receipt for income tax purposes. Emphasis was placed upon the fact that the agreements were exclusive and the payments were held to be of a capital nature and were not assessable income.

An obvious instance of a lump sum paid on revenue account is to be found in the case of B.P. Australia Ltd. v. F.C. of T. (1965) 112 C.L.R. 386 at p. 394. The Federal Court also considered the question in
F.C. of T. v. Ilbery 81 ATC 4661; (1981) 38 A.L.R. 172. See particularly ATC p. 4669; A.L.R. p. 182 per Toohey J.

In this application the payment was made in relation to the grant of an exclusive licence and it remained payable irrespective of whether there was any user under the licence. Due to these circumstances and as there is nothing to suggest that the taxpayer is a dealer in patent rights, I prefer to follow the decision of Campbell J. in the Kwikspan case and to hold the lump sum payment to be of a capital nature.

Thus, since the payment does not fall within the general law meaning of royalty and as it is of a capital nature, it is not assessable income of the taxpayer under sec. 26(f) of the Act. The assessment under review is therefore set aside and the taxpayer's objection is allowed.