Edited version of private advice

Authorisation Number: 1051708441348

Date of advice: 13 July 2020

Ruling

Subject: Tax treatment of share of commercialisation income

Question 1

Are the pre-monetisation distributions as share of the net commercial income in recognition of the taxpayer's contribution to scientific research and discovery of a pharmaceutical product, royalties under subsection 6(1) of the Income Tax Assessment Act 1936 (ITAA 1936), therefore assessable income to the individual under section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

No. The pre-monetisation distributions are not royalties under subsection 6(1) of the ITAA 1997. The distributions are considered ordinary income and therefore, assessable under section 6-5 of the ITAA 1997.

Question 2

Is the post-monetisation distribution as share of the partial sale of royalty rights in a product, proceeds from the sale of a CGT asset as defined in section 108-5, therefore assessable under section 102-5 of the ITAA 1997?

Answer

No. The post-monetisation distribution is not capital proceeds from the sale of a CGT asset. The distribution is considered ordinary income and therefore, assessable under section 6-5 of the ITAA 1997.

This ruling applies for the following periods:

Year ended 30 June XXXX

Year ended 30 June XXXX

Year ended 30 June XXXX

Year ended 30 June XXXX

Year ended 30 June XXXX

The scheme commences on:

28 September XXXX

Relevant facts and circumstances

As a condition of employment with a medical research organisation (the Organisation), the taxpayer is required to sign and comply with the Intellectual Property Declaration, which provided among other things:

·         Any intellectual property (IP) resulting from research work shall be owned by the Organisation;

·         Details of all IP arising from research work must be made available to the Organisation so it can protect its and the inventors' interests in that IP;

·         In the event the Organisation decides to get statutory protection for any IP, such application shall be filed in the Organisation's name at their expense. The inventors shall do everything necessary to assist the Organisation, to apply for, prosecute and maintain the patent including signing all necessary documentation and formally assigning the IP to the Organisation;

·         The obligations of the taxpayer and other researchers as set out in the declaration are continuing and shall survive termination of employment or the time spent undertaking research at the Organisation; and

·         All royalties or other income derived from the commercialisation of IP shall be distributed in accordance with the Organisation's Royalty Distribution Policy.

Development and commercialisation of pharmaceutical product

The research collaboration between the Organisation and a drug company resulted to a pharmaceutical product. The Organisation entered into a research collaboration agreement with the drug company. Under the agreement, the drug company had rights to commercialise the compounds developed during the research period including the pre-existing compounds with the Organisation prior to executing the agreement. The drug company also had corresponding obligations to make milestone and royalty payments.

It is stated the drug company developed the pharmaceutical product and presumably, the company was also the registered owner of the patents relating to the development of the product.

The Organisation confirmed it does not have an ownership interest in any of the patents that cover the product on which royalty is received. The Organisation merely has rights to the royalties.

The taxpayer has been identified by the Organisation as one of the inventors and contributors to the scientific research that led to the development of the pharmaceutical product including being named as one of the inventors on licenced patents of some of the compounds related to the development of the product.

However, the taxpayer has not been named as an inventor on any of the registered patents that cover the product on which royalty is received.

The Organisation generated commercial income (being milestone and royalty payments received from the drug company for its royalty rights) relating to the commercialisation of the product.

The Organisation approved the distribution of a certain percentage of the net commercial income to eligible individuals in two income years. The distribution is made in accordance with the Guidelines for distribution of commercial income determined by the Organisation.

Guidelines for distribution of commercial income

The Guidelines for Distribution of Commercial Income are an elaboration of certain provision of the Intellectual Property and Commercial Relations Policy and Procedures of the Organisation. The said Guidelines maybe amended by the Organisation if necessary.

The Guidelines define 'commercial income' to include up-front payments, milestone payments and royalties associated with specific collaboration and/or licensing agreements received by the Organisation. The 'net commercial income' is defined as the amount of commercial income from an agreement (including one that pertains to licensing of Patents) after paying any directly related expenses from the gross amount received.

The inventor's share of the net commercial income is distributed based on a modified formula taking into consideration seminal contributors to securing commercial income.

The Guidelines have been revised and some of the changes are:

·         'commercial income' relevantly refers to up-front, milestone and royalty payments from specific collaborations and/or licensing agreements; and monetisation payments made in exchange for part or all of a future commercial income stream.

·         'net commercial income' is defined as the amount of commercial income the Organisation receives from an agreement after discharging obligations to third parties (e.g. collaborating Organisations) and after recouping expenses incurred in commercialising the project.

·         'monetisation' refers to when the Organisation decides to monetise an income stream from a commercial deal - that is, accept an up-front payment from a third party in exchange for part or all of the future commercial returns from the project. For the purposes of calculating net commercial income, the up-front payment received from monetisation, net of directly attributable costs will be spread across the period that the income is anticipated to be generated such as the expiry date of patents generating the income stream or the expected monetisation cap period.

·         introduction of the entitlement register - at the start of the commercialisation project, Contributors as defined in the Guidelines would be identified and entitlements were allocated to the Contributors. At the end of each financial year, allocations of each project's net commercial income to the Contributors on that project will be determined based on their entitlements and the timing of the generation of the net commercial income. If the Contributor dies, their share of net commercial income will be paid to their estate.

Product monetisation event/income

The Organisation made a landmark deal on the partial sale of royalty rights in the pharmaceutical product. The transaction included an up-front cash payment and potential milestone payments to the Organisation.

Entitlement to share of net commercial income from product commercialisation projects

The taxpayer has been identified as one of the inventors named on licenced patents related to the development of the pharmaceutical product. The Organisation has approved the distribution of a percentage of the net commercial income generated by the product commercialisation project. The taxpayer's entitlement is proportional to the taxpayer's contribution to the development of the product.

The taxpayer received pre-monetisation distributions relating to the royalty payments received by the Organisation from the drug company. The taxpayer also received post-monetisation distribution relating to the partial sale of royalty rights by the Organisation.

The taxpayer may be entitled to royalty payments in future years. The Organisation has provisions to make future distributions to product Contributors. Payments will be made every year to eligible Contributors up to and including the year of expiry of the global patents.

Following the monetisation of the product (partial sale of royalty rights), a total gross amount has been approved for distribution to Contributors. This total gross amount will be approximately the same each year up to and including the year of expiry of patents. However, the payment amounts may vary from year to year due to continuing commercialisation costs that may be incurred and future roles and efforts of other Contributors.

The Organisation advised that the taxpayer as a contributor, may be eligible to receive royalty payments in future years, even after ceasing employment with the Organisation.

Relevant legislative provisions

Income Tax Assessment Act 1936

Subsection 6(1)

Paragraph 6(1)(d)

Income Tax Assessment Act 1997

Section 6-5

Section 102-5

Section 108-5

Subsection 995-1(1)

Reasons for decision

Question 1

Subsection 995-1(1) of the Income Tax Assessment Act 1997 (ITAA 1997) provides royalty has the meaning given by subsection 6(1) of the Income Tax Assessment Act 1936 (ITAA 1936).

Relevantly, subsection 6(1) of the ITAA 1936 provides:

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;

b)    .....

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), ..... or any such knowledge or information as is mentioned in paragraph (c);

e)    .....

f)     a total or partial forbearance in respect of:

                                              i.        the use of, or the granting of the right to use, any such property or right as is mentioned in paragraph (a)

                                             ii.        the supply of any such knowledge or information as is mentioned in paragraph (c) or of any such assistance as is mentioned in paragraph (d);

Section 6-5 of ITAA 1997 provides that the assessable income of an Australian resident for taxation purposes, includes income according to ordinary concepts (ordinary income) derived directly or indirectly from all sources. Some of the provisions about assessable income listed in section 10-5 may affect the treatment of ordinary income.

Subsection 6-5(4) of the ITAA 1997 provides that in working out whether you have derived an amount of ordinary income, and (if so) when you derived it, you are taken to have received the amount as soon as it is applied or dealt with in any way on your behalf or as you direct.

There is no statutory definition of 'ordinary income'. As a general proposition, a receipt is ordinary income if it is a product of the provision of personal services, business activities or a passive investment.

Certain characteristics of income that have evolved from case law include receipts that are earned, expected, relied upon and have an element of periodicity, recurrence or regularity. There is no definitive test to determine whether an item of receipt is ordinary income. The whole circumstances of a certain case will need to be examined.

Application to your circumstances

Extended definition of royalty

The pre monetisation distributions made by the Organisation as the taxpayer's share of the net commercial income in recognition of the taxpayer's contributions to scientific research and discovery of a pharmaceutical product are not 'royalty' payments to the taxpayer within the extended definition of royalty in paragraph 6(1)(d) of the ITAA 1936.

The taxpayer argued that the extended definition of royalty in paragraph 6(1)(d) of the ITAA 1936 would be applicable to the payments (distributions), citing paragraph 28 of Taxation Ruling IT 2660 which detailed the three important elements which could be used as basis for distinguishing between a contract for the supply of know-how and one involving the rendering of services (paragraph 29 of the Ruling).

It's highlighted as contained in the Ruling that one of the distinguishing elements for the supply of know-how is noted as a "product" which has already been created or developed or is already in existence is transferred. The taxpayer believed this is the case with the distributions the taxpayer received because they are for a "product" in which the taxpayer had contributed to previously, and the "product" (such as knowledge, information, intellectual property) had already been created and developed, and capable of being sold to third parties.

The taxpayer also argued that under the extended definition of 'royalty' in paragraph 6(1)(d), the existence of a direct ownership is not a factor in determining whether a payment is royalty or not.

There's no evidence to support the application of the extended definition of royalty in paragraph 6(1)(d) of the ITAA 1936 in the circumstances of the taxpayer.

The Intellectual Property relating to the commercialisation of the pharmaceutical product is owned by the Organisation. The taxpayer was not a party to a transaction and/ or any contract requiring the taxpayer to supply any assistance that is ancillary and subsidiary to, and is furnished as a means of enabling the application and/ or enjoyment of, any such property or right as is mentioned in paragraph (a), or any such knowledge or information as is mentioned in paragraph (c) of subsection 6(1) of the ITAA 1936.

In particular, there's no evidence provided that the taxpayer was a party to any contract when the Organisation entered into a research collaboration agreement with certain drug companies requiring the taxpayer to do certain things as contemplated within the extended definition of royalty under paragraph 6(1)(d).

The research collaboration agreement entered between the Organisation and the drug companies gave one drug company rights to commercialise the compounds developed during research; and the company had obligations to make milestone and royalty payments.

It is noted however, that there's no evidence the taxpayer was a party to such agreement.

IT 2660 provides guidelines to distinguish between royalty payments and payments for services. The Ruling explains the difference between a contract for the supply of know-how and a contract for the rendering of services.

Based on the facts, the pre-monetisation distributions you received were not in accordance to any contract you were a party to as explained in IT 2660.

Therefore, the pre-monetisation distributions you received from the Organisation are not considered 'royalty or royalties' within the extended definition in paragraph 6(1)(d) of the ITAA 1936.

Tax treatment of your share of commercialisation income (pre-monetisation distributions)

As stated in the Organisation's Distribution Guidelines, individuals are recognised as Contributors and eligible for distribution of net commercial income when, among other things:

·         the primary purpose of their appointment to the Organisation, in which capacity the contribution was made, was to conduct research;

·         they have signed the Organisation's Intellectual Property (IP) Deed Poll (to assign all the right, title and interest in any IP developed or created by them in the course of using the Organisation's funding, facilities or resources, in accordance with Organisation's IP and Patents Policy); and

·         the Organisation has the right to exploit and commercialise their IP.

The Organisation has a policy to distribute its net commercial income (the balance of royalty payments, up-front payments and other income received, after deducting any obligations to third parties and relevant expenses incurred by the Organisation) to people who contribute to the commercialisation of their research (commercialisation project). Distribution is made on an annual basis and there is a cap on the amount to be distributed per annum to each contributor and eligible individual.

The taxpayer had done scientific research work for the Organisation; consented that the Organisation would own any of the IP resulting from their research work; and the Organisation have the right to exploit and commercialise the IP. Consequently, the Organisation would have ownership of the royalty rights if the taxpayer's research work would lead to a successful product.

As a Contributor to the discovery and development of the pharmaceutical product, the taxpayer received pre-monetisation distributions (annual payments) as their share of the net commercial income gained and derived by the Organisation on the commercialisation of the product. The annual payments are expected, periodic; relied on and have an element of recurrence.

As such, the pre-monetisation distributions are considered ordinary income. Therefore, the pre-monetisation distributions are assessable to the taxpayer under section 6-5 of the ITAA 1997.

Question 2

Section 102-5 of the ITAA 1997 includes a net capital gain in the assessable income of a taxpayer. Broadly, a net capital gain is the difference between a taxpayer's capital gains and capital losses for an income year. A capital gain or capital loss is made when a CGT event happens to a CGT asset.

A CGT asset is defined as any kind of property, or a legal or equitable right that is not property: subsection 108-5(1) of the ITAA 1997. Relevantly, to avoid doubt, a part of, or an interest in, an asset referred to in subsection (1), is a CGT asset: subsection 108-5(2). Examples of CGT assets include land and buildings; shares in a company and units in a unit trust; options; debts owed to you; a right to enforce a contractual obligation; and foreign currency.

Section 6-5 of ITAA 1997 provides that the assessable income of an Australian resident for taxation purposes, includes income according to ordinary concepts (ordinary income) derived directly or indirectly from all sources. Some of the provisions about assessable income listed in section 10-5 may affect the treatment of ordinary income.

Subsection 6-5(4) of the ITAA 1997 provides that in working out whether you have derived an amount of ordinary income, and (if so) when you derived it, you are taken to have received the amount as soon as it is applied or dealt with in any way on your behalf or as you direct.

There is no statutory definition of 'ordinary income'. As a general proposition, a receipt is ordinary income if it is a product of the provision of personal services, business activities or a passive investment.

Certain characteristics of income that have evolved from case law include receipts that are earned, expected, relied upon and have an element of periodicity, recurrence or regularity. There is no definitive test to determine whether a receipt is ordinary income. The whole circumstances of a certain case will need to be examined.

The initial and most important enquiry is to determine the character of the payment in the hands of the recipient having regard to the totality of the circumstances - see FCT v Anstis (2010) 76 ATR 735.

Application to your circumstances - Sale of royalty rights and post-monetisation payments

The Organisation has ownership of the royalty rights in the pharmaceutical product. The up-front payment received by the Organisation for the partial sale of its royalty rights in the product may be a capital or revenue receipt to the Organisation, depending on how the up-front payment was determined.

The character of the payment in the hands of the Organisation (payer) does not determine its character in the hands of the taxpayer as the recipient. Whether the receipt constitutes income or capital in the taxpayer's hands will depend on the circumstances and the reasons why the payment was made to the taxpayer.

The post-monetisation distribution was paid to the taxpayer, being their share of the net commercial income gained and derived by the Organisation from the product commercialisation project in recognition of the taxpayer's contribution in the discovery and development of that product.

As contained in the Distribution Guidelines, the Organisation's commercial income includes up-front payments and monetisation payments received in exchange for part or all of a commercial income stream.

The Organisation sold its royalty rights in the pharmaceutical product for a lump sum amount which is the present value of the future royalty income the Organisation would have received. As such, the sale of the royalty rights by the Organisation is simply converting its future royalty income into present income. This is referred to as 'monetisation'; the term is defined in the Distribution Guidelines.

The taxpayer advised that the Organisation decided to distribute the net commercial income from its sale of royalty rights to the Contributors over the lifetime of the patents.

The post monetisation distribution which the taxpayer received was the first distribution from the 'post monetisation distribution stream' which the taxpayer is entitled to receive every year over the lifetime of the patents subject to approval by the Organisation.

The post monetisation distribution represents the taxpayer's share of the Organisation's net commercial income which includes the up-front payment received by the Organisation from the partial sale of its royalty rights in the pharmaceutical product.

The post monetisation distribution stream is expected, periodic and/ or recurrent and relied on. As such, it is considered ordinary income and therefore, assessable to the taxpayer under section 6-5 of the ITAA 1997.

Accordingly, the receipt of post monetisation distribution by the taxpayer from the Organisation following the partial sale of the royalty rights by the Organisation is not consideration or capital proceeds for the sale of the royalty rights in the hands of the taxpayer.

Entitlement to share of net commercial income

The taxpayer signed the Intellectual Property (IP) and Patents Policy Declaration as a condition when the taxpayer joined and worked for the Organisation. In doing so, the taxpayer effectively assigned to the Organisation their interest in the IP resulting from their scientific research work. The assignment includes any rights in respect of the IP such as the use and commercialisation of the IP. As a result of the assignment, the Organisation has ownership of the royalty rights if the research work would lead to a successful product.

Accordingly, the assignment did not create a legal right for the taxpayer:

·         to require payment on demand from the Organisation in respect of the assignment; or

·         to demand for any payment in relation to the commercialisation of the IP; or

·         to demand payment for a share of the income generated from the royalty rights owned by the Organisation.

The Distribution Guidelines state that all net commercial income distributions are made at the discretion of the Organisation.

Accordingly, the taxpayer's entitlement to the share of the net commercial income gained and derived by the Organisation is contingent subject to the discretion of the Organisation. The taxpayer's entitlement does not exist until the Organisation approves the distribution for each year.

Following approval of the distribution by the Organisation, the taxpayer's entitlement may satisfy the definition of a CGT asset in section 108-5. CGT event C2 may happen when the entitlement is satisfied when the distribution is made to the taxpayer by the Organisation. The taxpayer may have a cost base of zero for the entitlement as the taxpayer has not paid for it, resulting to a capital gain equal to the amount of the distribution.

However, the anti-lap provision in section 118-20 of the ITAA 1997 would apply to reduce the capital gain from the event to the extent the distribution amount is assessed to the taxpayer under section 6-5 of the ITAA 1997.

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