Edited version of private ruling

Authorisation Number: 1011707450681

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Ruling

Subject: Whether the licence fee is assessable income

Question

Is the licence fee received from the company included as part of the assessable income of the taxpayer?

Answer

Yes.

This ruling applies for the following period:

Year ended 30 June 2010

The scheme commences on:

1 July 2009

Relevant facts and circumstances

An arrangement was entered into between the parties to conduct a business between the principal and a business associate.

Prior to this time, the principal had conducted a similar business using a trading entity which had been placed into administration.

The arrangement was entered into as the principal needed time to raise working capital and another business structure in order to recommence trading.

The principal utilised the taxpayer, which is a trust, which was in existence at the time that he owned and controlled to contract with the business associate on the following basis.

An agreement was entered into where the taxpayer would provide all of the supplier and customer contacts and distribution channels to operate the business in exchange for a licence fee.

An agreement was also entered into where the business associate (or his related entities) would provide warehousing, office infrastructure, and working capital on a fee for service basis.

As part of this agreement, the business associate provided the working capital and business structure via an entity he controlled, being the company, for which the company charged a management fee.

The business operations were managed by the principal, and they were paid a salary from the company for the work performed.

The company recorded profits from the business for the period that it operated in the income year. The company returned this profit in its income tax return and paid tax on the profits accordingly. However it did not distribute the remaining profits to its shareholders.

The agreements mentioned above were not exercised during the income year as the parties were still trying to get the importing business off the ground and to build working capital within the business.

The business remained profitable so the respective parties have exercised the various agreements as follows:

· the company has charged the management and service fees to recoup the costs for the use of the business structures, warehousing etc;

· the principal has been paid a salary for managing the importing business

· the taxpayer has invoiced the business the licence fee for the use of the supplier and customer contacts as well as all of the distribution channels.

The last invoice is the subject of this ruling request.

The invoice from the taxpayer has charged a set percentage of gross sales for the use of the licence.

There are no similar licences, so to ensure that the rate was commercial, the parties compared the rates charged in similar industry licencing arrangements in the wholesale sector. The average advertising spending was then aggregated and the result was an amount just below the set rate on the gross sales. As this comparison still did not quite equate with what was actually provided for in this agreement, a small premium was added which resulted in the set rate of gross sales amount shown on the invoice.

Eventually the principal managed to put together enough money to provide for another trading entity and sufficient working capital so that he could once again operate the importing business himself.

As a result, all of the arrangements listed above were terminated, and the importing business recommenced in another entity wholly owned by the principal from late in the income year. This included resigning as an employee of the company and the termination of the two agreements for the use of the company's business structures and the use of the importing suppliers and customers.

Further information was requested, including the invoice for the licence fee. This invoice was provided and is attached. In the end, the invoice covered the period from the commencement in the income year to the end of the agreements, and the amount was also shown on the invoice. The invoice was based on gross sales (or total revenue as the invoice puts it). A calculation indicates that the arithmetic is correct.

The original agreement between the principal and the business associate was a verbal handshake between the two parties, so there is no written agreement formalising this original arrangement.

The principal has stated that the amount shown on this invoice currently remains outstanding, as the parties are awaiting the decision on the private ruling request before settling.

The two parties are not related in any way, but have known each other as friends for some time before this arrangement took place.

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 995-1 and

Income Tax Assessment Act 1936 Subsection 6(1).

Reasons for decision

Summary

The 'licence fee' as shown on the invoice will need to include as assessable income by the taxpayer.

As this amount has not been paid at the time of writing, the taxpayer will need to determine in which year the amount will be included as assessable income, which will depend on whether the cash or accruals method of accounting should be used. This issue has not been considered in the ruling.

Detailed reasoning

Section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997) includes income according to ordinary concepts derived directly or indirectly as assessable income.

Income according to ordinary concepts is not a defined term, but instead is based on common law and case law.

Section 6-10 of the ITAA 1997 includes statutory income as assessable income, provided that it has not already been included as ordinary income.

Royalty is defined in section 995-1 of the ITAA 1997 to be the same as the definition is section 6 of the Income Tax Assessment Act 1936 (ITAA 1936)

The definition of royalty in sub-section 6(1) of ITAA 1936 is quite long, but the part relevant here is an amount paid or credited, however described or computed, whether the payment is periodical or not, as consideration for either:

· the use of, or the right to use, any copyright, patent, design, model, plan, secret formula or process, trademark or other like property or right; or

· the supply of scientific, technical, industrial, or commercial knowledge or information.

In this case, the request is considering an invoice which applies for the period from the commencement of the income year to when the agreement was terminated. The amount shown on the invoice is calculated as a set percentage of the gross sales received during that period. On the face of it, the receipt of monies from an invoice calculated on the basis of gross sales from the business operations would constitute ordinary income, provided that everything is on a bona fide arms length basis.

In this case the invoice is for the use of 'knowledge' held by the principal who was in the form of contacts with overseas suppliers, Australian customers, and with the various distributers. The use of this 'knowledge' would have eliminated the usual start up problems that most new businesses have in reaching their sales targets, in that the importing business operated by the company would have been up to full speed very quickly with a full customer and supplier book from the 'knowledge' provided by the principal via the taxpayer. The result of the use of this information was that the business was profitable immediately, with gross sales of over $3 million dollars in that short period of time.

Therefore there is a definite link between the use of this information and the amount of sales generated by the fabric importation business operated by the company. It would not be surprising if the gross sales would have been reduced by a lot more than the set rate being charged under this invoice, if this 'knowledge' was not made available to the company.

The mere fact that the payment will be a single receipt payable at the end of the period does not affect whether the amount is considered to be income. This issue was considered in Federal Commissioner of Taxation v. The Myer Emporium Ltd (1987) 163 CLR 199; 87 ATC 4363; 18 ATR 693 where the High Court considered that amounts calculated in the form of interest are assessable income even if the payment was made in one lump sum payment.

This means that even though in this case, the calculation of the amount shown on the invoice was made at the end of the term, the fact that it was calculated on the basis of a set percentage of gross sales would make the payment income and therefore assessable as income according to ordinary concepts under section 6-5 of the ITAA 1997 in the year that the income was derived.

In the alternative, even if this is not the case, and the amount would not be included as assessable income under section 6-5 of the ITAA 1997 as income from ordinary concepts, the payment would be covered by the definition of royalty as set out in sub-section 6(1) of the ITAA 1936, being the proceeds from the supply of commercial information. This would result in the amount derived from the invoice being included either as assessable income under section 6-5 of the ITAA 1997, or as statutory income under section 6-10 of the ITAA 1997.

Taxation Ruling IT 2660 provides the Commissioner's view of what is covered by the definition of royalty under sub-section 6(1) of the ITAA 1936. The invoice under review would be included as a royalty according to that ruling.

There is also a third option if these two arguments do not apply. Taxation Ruling TR 92/3 outlines whether amounts received from isolated transactions are included as assessable income. Paragraph 6 of TR 92/3 states the following:

6. Whether a profit from an isolated transaction is income according to the ordinary concepts and usages of mankind depends very much on the circumstances of the case. However, a profit from an isolated transaction is generally income when both of the following elements are present:

(a) the intention or purpose of the taxpayer in entering into the transaction was to make a profit or gain; and

(b) the transaction was entered into, and the profit was made, in the course of carrying on a business or in carrying out a business operation or commercial transaction.

This transaction was entered into on a commercial basis with the intention to make a profit or gain, so if the previous arguments fail in relation to the proceeds from the invoice being assessable income, then TR 92/3 would apply to make the amount derived assessable income in the year that it is derived.

The next issue is the payment. The invoice was issued during the 2009-10 income year, and all of the 'knowledge' was provided before the issue of the invoice. The work has therefore all been performed.

When the income is derived is considered in Taxation Ruling TR 98/1 and depends on whether the entity was using the cash or accruals method of accounting. In this case, the income was earned as a result of the provision of 'knowledge' to a commercial business operation. The taxpayer is a trust and so would be entitled to use either the cash or accruals method. Provided the accruals method of accounting has been chosen, then the amount would be assessable in the 2009-10 income year as all of the work has been performed, and the invoice has been issued. If the cash basis of accounting has been used, then the amount would not be assessable until the payment was actually received. Paragraph 48 of TR 98/1 has concluded that in most cases, rent or royalties would be assessable on a receipts basis, but leaves it open for the royalties to be assessed on an earnings or accruals basis if the receipt of the royalties constitutes business operations.

The last item to consider is the relationship between the parties. The two people, the principal and the business associate were friends prior to the agreement being made, but are not related to each other. The agreement itself has been made on a commercial footing. The question is whether the various contracts have been made on an arms length basis. If there is any doubt, then Taxation Ruling TR 95/33 requires that the intention and purpose of the transactions be considered.

The basic reasoning was that the principal was operating the business, but it managed to get into difficulties, which resulted in the entity that was being used to operate the business being placed into administration.

This left the principal with a problem with the fabric importation business as the entity no longer existed and they didn't have a lot of money at that time. The business associate agreed to assist as they had some spare capacity in their own business operations and a handshake deal was done to incorporate the importing business into one of their entities. The company was the entity chosen by the business associate with that task.

The operations were on the basis that the business associate would be compensated fully for the additional expenses that the company or any other related entity was to provide to operate the importing business. An agreement was drawn up to satisfy this requirement. The second part was that principal would be employed by the company to manage the business, and he was paid a salary for the services rendered. There are no issues with these agreements, provided that the rates were commercially realistic.

The third agreement was the one which is the subject of the ruling. To assist in making the business profitable, the principal was required to make available all of the 'knowledge' or know how that he had picked up over the years, so that the business would operate the same way that it had previously. Part of that was by becoming an employee to manage the business operations. The remaining information, being the suppliers, customers, and the supply chain information, would allow the new business to run profitably without the usual start up problems that a wholesale business would encounter.

An agreement was made on the basis that the 'knowledge' would be made available to the company on a percentage of gross income basis, in that case at the set rate of gross. The question is whether it is considered that this agreement was commercially realistic. There was no direct comparison available. Therefore, information was provided in relation to similar wholesale operations which came out at about just below the set rate, but with slightly different things being provided.

As a result of that information, it is considered that the set rate percentage arrived was made using a commercially realistic methodology. Therefore there is no reason to consider that there are any issues in relation to the purpose or intention of the transaction. Therefore the method of calculation of this invoice will be accepted as valid.

The last issue is whether the use of the taxpayer to supply this 'knowledge' is acceptable. The 'knowledge' itself would be an intangible asset of some variety as its use would have some value to the company. The issue is who owns this 'knowledge'. If it is actually owned by the taxpayer, it would be capable of earning income from the use of this 'knowledge'.

Previously it would have been an intangible asset used by a related entity as it was previously carrying on the business prior to it having gone into administration.

As this was the case, there is no specific reason why it could not have been transferred from the previous related entity to the taxpayer when the administration commenced to allow it to profit from the use of the information.

If that was not the case, then it would have been as asset of the principal himself. In order for the taxpayer to declare the income, the asset would need to be transferred to it.