Edited version of private ruling

Authorisation Number: 1011712875549

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Ruling

Subject: Acquisition of software intellectual property

Question 1

Will the taxpayer be entitled to an income tax deduction under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) with respect to the expenditure incurred in the acquisition of software intellectual property?

Answer

No.

Question 2

If the answer to question 1 is no, can the software protected by copyright be written-off for income tax purposes by the taxpayer over 25 years under Division 40 of the ITAA 1997?

Answer

Yes, over the shorter of 25 years or the period until the copyright ends

This ruling applies for the following periods:

Year ending 31 December 2011

Year ending 31 December 2012

Year ending 31 December 2013

Year ending 31 December 2014

The scheme commences on:

1 January 2011

Relevant facts and circumstances

The taxpayer is a supplier of software solutions and information in Australia and several other countries. The taxpayer has subsidiaries in Australia and other countries.

The taxpayer entered an agreement to purchase software and associated intellectual property rights from the vendor.

The acquired software is protected by legislation enacted in the vendor's country.

The taxpayer also entered an agreement to purchase all of the shares in the vendor.

The acquisition of the software IP and the acquisition of shares were completed under two separate agreements. The acquisitions will be accounted for separately as the purchase of software and the purchase of shares.

Subsequent to acquisition, the applicant has stated that the taxpayer intends to amortise the cost of the software over a period of five years for accounting purposes under AASB 138, Intangible Assets.

Relevant legislative provisions

Income Tax Assessment Act 1997 - section 8-1

Income Tax Assessment Act 1997 - paragraph 8-1(2)(a)

Income Tax Assessment Act 1997 - subsection 40-25(1)

Income Tax Assessment Act 1997 - subsection 40-30(1)

Income Tax Assessment Act 1997 - subsection 40-30(2)

Income Tax Assessment Act 1997 - section 995-1

Income Tax Assessment Act 1997 - section 70-10

Income Tax Assessment Act 1997 - subsection 40-95(7)

Further issues for you to consider

It is noted that the ruling does not address valuations of assets.

Does Part IVA apply to this ruling?

Part IVA of the Income Tax Assessment Act 1936 (ITAA 1936) is a general anti-avoidance rule that can apply in certain circumstances if you or another taxpayer obtains a tax benefit in connection with an arrangement and it can be concluded that the arrangement, or any part of it, was entered into or carried out by any person for the dominant purpose of enabling a tax benefit to be obtained. If Part IVA applies the tax benefit can be cancelled, for example, by disallowing a deduction that was otherwise allowable.

We have not fully considered the application of Part IVA of the ITAA 1936 to the arrangement you asked us to rule on, or to an associated or wider arrangement of which that arrangement is part.

If you want us to rule on whether Part IVA of the ITAA 1936 applies we will first need to obtain and consider all the facts about the arrangement which are relevant to determining whether Part IVA may apply.

For more information on Part IVA of the ITAA 1936, go to our website www.ato.gov.au and enter 'part iva general' in the search box on the top right of the page, then select: Part IVA: the general anti-avoidance rule for income tax.

Question 1

Summary

The outgoing is considered to be an outgoing of capital, or of a capital nature and is therefore not deductible due to the operation of paragraph 8-1(2)(a) of the ITAA 1997.

Detailed reasoning

Section 8-1 of the ITAA 1997 allows a deduction for any loss or outgoing incurred in gaining or producing assessable income, or that is necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income except to the extent that such loss or outgoing is, inter alia, of capital, or of a capital nature.

For losses and outgoings incurred in carrying on a business, the term 'necessarily incurred in' is taken to mean 'clearly appropriate or adapted for' (Ronpibon Tin NL v. Federal Commissioner of Taxation (1949) 78 CLR 47; (1949) 8 ATD 431; (1949) 4 AITR 326).

It is the stated business model of the taxpayer to acquire and hold in Australia all software based intellectual property rights which are considered as having potential for use elsewhere in its global group. The assessable income of the taxpayer will include amounts that are attributable to the licensing of the vendor's and the taxpayer's software in the vendor's country. The expenditure is integral to the production of the taxpayer's business income and therefore the expenditure is considered to be 'necessarily incurred in' the course of carrying on that business.

However, it must also be determined whether or not that expenditure is excluded from deductibility on the basis that it is capital, or of a capital nature.

Capital or of a capital nature

The decision in Sun Newspapers Ltd v. Federal Commissioner of Taxation (1938) 61 CLR 337 (Sun Newspapers) is a leading authority on the distinction between revenue and capital expenditure, where his Honour said at 363:

There are, I think, three matters to be considered, (a) the character of the advantage sought, and in this its lasting qualities may play a part, (b) the manner in which it is to be used, relied upon or enjoyed, and in this and under the former head recurrence may play its part, and (c) the means adopted to obtain it; that is, by providing a periodical reward or outlay to cover its use or enjoyment for periods commensurate with the payment or by making a final provision or payment so as to secure future use or enjoyment.

More recently in GP International Pipecoaters Pty Ltd v. Federal Commissioner of Taxation (1990) 170 CLR 124; 21 ATR 1; 90 ATC 4413 the High Court pointed out that the character of expenditure is ordinarily determined by reference to the nature of the asset acquired and that the character of the advantage sought by the making of the expenditure is a critical factor in determining the character of what is paid.

In the present instance, the subject of the acquisition is all of the intellectual property rights, including software, trademarks and domain names of the vendor. Although this ruling only concerns the expenditure on intellectual property (IP), the acquisition of IP was linked to and dependent on the separate acquisition by the taxpayer of all the shares in the vendor.

Character of advantage sought

In considering the character of the advantage sought and the light it sheds on the character of the expenditure, it is necessary to take into account numerous factors including the taxpayer's intentions and the form and manner of the transactions. Dixon J in Hallstroms Pty Ltd v. F.C. of T. (1946) 72 CLR 634 at 648 highlighted the need to consider:

...what the expenditure is calculated to effect from a practical and business point of view, rather than upon the juristic classification of the legal rights, if any, secured, employed or exhausted in the process.

The comments of Windeyer J in BP Australia Ltd v. Federal Commissioner of Taxation (1965) 112 CLR 386; (1965) 14 ATD 1; (1965) 9 AITR 615 (BP Australia) show the need to focus on what the taxpayer got in return for the expenditure:

Regard ought therefore to be had to what it was sought to acquire and to the relation of that to the taxpayer's undertaking or business. These, rather than the form of the transaction or the mechanics of the acquisition, are what appear to me to be deciding factors. In other words, it is what the particular taxpayer got for his money, rather than how he got it that is important.

The Commissioner considers that the taxpayer's intentions are relevant, though not solely decisive, in determining the character of the advantage sought. In this regard, reference is made to the comments of Lord Wilberforce in Regent Oil Co Limited v. Strick (Inspector of Taxes) (1965) 3 All ER 174.

The case of Regent Oil concerned the treatment of payments made by an oil company to a garage proprietor to secure the sale of their petrol. The form of the tie was known as a lease-sub-lease transaction, whereby the proprietor granted the suppliers a lease of the premises for the period of the tie in consideration for the payment of a lump sum. The lump sum was calculated on the gallonage likely to be sold during the period of the lease plus a nominal rent.

In determining that the lump sum payments were expenditure of a capital nature, Wilberforce J made the following comments:

On behalf of the taxpayers it was said that we must look through the transparent form of the lease-sub-lease to some underlying commercial reality and that, having performed this penetration, we should see that this was merely part of Regent's normal marketing operations, or, alternatively, that the payments were nothing but disguised rebates. I cannot accede to this. Without embarking here on the question how far it is permissible in taxation matters to go behind the legal forms which the parties have chosen, where these forms are not a mere sham, I am satisfied that in this case form and substance fully coincide.

On the basis that the taxpayer's Agreement for acquisition of the IP is bona fide, the Commissioner's decision regarding what the expenditure of the taxpayer was calculated to effect is based on both the form and substance, that is, the 'underlying commercial reality' of the transaction.

The taxpayer's position is that when consideration is given to the substance of the transaction, the expenditure was intended to gain access to the customers of the vendor, not the use and enjoyment of the software. The expenditure was part of the commercial imperative to increase its customer base for taxable profit. The vendor has a significant share of the market in which they operate.

The taxpayer contends that the customer base which secured through the acquisition will be invaluable and is a key driver to the acquisition.

The taxpayer has a history of acquisitions which the applicant claims shows a strategy to develop and grow their business through synergistic acquisitions which provide access to broader market participation and opens avenues for greater penetration within their space. It is submitted that, in varying degrees, the transactions illustrate a business model in which the taxpayer uses acquisitions as a mean to gain further customers for its existing products, gain new or enhanced products to offer to existing customers or both.

The Commissioner's position is that the taxpayer secured more than merely the customers of the vendor in return for the cost of entering into the Agreement. It secured the exclusive rights to the software and associated intellectual property for use in its business.

The Commissioner considers that the taxpayer got more than a customer base and the fact that the taxpayer intends to migrate customers to its own consolidated software platform at some stage in the future does not colour the character of the expenditure.

The expenditure expanded the size of the software holding of the taxpayer, thereby resulting in an enlargement of the profit yielding structure of the business.

The manner in which the advantage is to be used, relied upon or enjoyed

All business expenditure is likely to be made with the intention of securing some commercial advantage. What is necessary to establish is the effect of the expenditure and how long it will likely endure. Where the expenditure results in an intangible benefit or advantage, it is necessary to establish whether the asset is sufficiently substantial and enduring to count as capital.

The 'enduring benefit test' suggests that if a loss or outgoing gives rise to a benefit of an enduring nature, the loss or outgoing is more likely to be capital in nature. The test arose to prominence in British Insulated and Helsby Cables Ltd v. Atherton [1926] AC 205 where it was held that an employer contribution to establish a staff pension fund was capital in nature on the basis that it brought into existence an asset of 'enduring benefit'. Viscount Cave LC at 192 made the following statement on the characteristics of capital expenditure:

When an expenditure is made, not only once and for all, but with a view to bring into existence an asset or advantage for the enduring benefit of a trade, l think that there is very good reason (in the absence of special circumstances leading to an opposite conclusion) for treating such an expenditure as properly attributable not to revenue but to capital.

It is noted that the term 'enduring' does not mean that the asset or advantage should last forever. This was supported in Commissioner of Taxes v. Nchanga Consolidated Cooper Mines Ltd [1964] 1 All ER 208 in which it was stated that 'permanent' does not mean 'perpetual'.

In the present case, the software expenditure was once and for all. With regard to its enduring nature, the copyright has a life of many decades from the date the works were first made available to the public and the trademarks can last indefinitely.

It has been stated that access to the vendor's customer base via the software rights is the advantage sought by the taxpayer. It is worth then considering enduring benefits from a customer and turnover point of view. Prior to the taxpayer allocating value to the software as a portion of the total purchase price for the vendor and its technology, negotiations with the vendor for a final purchase price were based on an enterprise value calculated using forecast free cash flows. It is noted that more than half of the indicated enterprise value is derived from cash flows expected beyond 2016. It is probable therefore that the benefits of the customer base will endure for many years to come.

It is also considered that through the acquisition of the vendor's IP, the taxpayer removed a strong competitor from the market. The competitor lost its rights to all of its software and intellectual property. Through the simultaneous share acquisition, an ownership interest in the remaining parts of the business was also achieved, together with restraints imposed on key staff from performing in the market. Together these acquisitions bring about an advantage of a permanent nature, and that is key to understanding the character of the advantage sought.

Further, the advantage the taxpayer gained from the purchase and subsequent removal of this competitor from the market, removed an opportunity for other competitors to utilise the same strategy. That could be said to be an advantage in itself equivalent to an enduring benefit.

The means adopted to obtain it

The consideration provided was a once and for all payment which secured the exclusive right to the software and IP of the vendor. No further payment was required to secure the assets. Not only was no further payment required, but the associated acquisition of the shares in the vendor secured ownership interests in other aspects of the vendor's business which were further boosted by restraint clauses which bind key executives from certain activities considered harmful to the taxpayer.

Consideration of case law

Regard has also been had to the judgments in BP Australia Ltd v. Federal Commissioner of Taxation (1965) 112 CLR 386; (1965) 14 ATD 1; (1965) 9 AITR 615 (BP Australia), National Australia Bank v. Federal Commissioner of Taxation (1997) 80 FCR 352; 97 ATC 5153; (1997) 37 ATR 378 (NAB) and Tyco Australia Pty Ltd v. FC of T [2007] FCA 1055; (2007) ATC 4799; 67 ATR 63 (Tyco).

In BP Australia the company claimed deductions for amounts paid as trade ties to service station proprietors so that those proprietors would deal exclusively in its products for a fixed period. The payments were calculated by reference to expected sales by the service stations. The Privy Council held that the real object of the outgoing was not the tied network but the orders that would flow from it. The tie agreements were a temporary solution that were of a recurrent nature. The advantage sought was the promotion of sales by up to date marketing methods which had become necessary and the expenditure was therefore deductible as being on revenue, rather than capital, account.

In NAB the bank was required to pay a lump sum (but further amounts were payable if loan quotas were exceeded) to the Commonwealth in order to have the exclusive right to make advances to Australian Defence Force personnel for a 15 year period. The Full Federal Court held that the payment was of a revenue nature as it did not enlarge the framework within which the Bank carried on its activities. Rather, it was incurred as part of the process by which the Bank operated to obtain regular returns by means of regular outlay. The Full Court determined that the payment was in the nature of a marketing expense and had a revenue rather than capital aspect.

In Tyco the electronic security monitoring company engaged contractors to secure customers and to enter into alarm monitoring contracts directly with those customers. The taxpayer then paid these contractors a lump sum for the novation of each contract. It was held that the payments were on revenue account as it did not go to the business structure. The winning of customers was achieved by the chosen method of organising and remunerating an independent, but controlled, sales force.

The Commissioner has distinguished the position of the taxpayer from that of BP Australia and NAB on the basis that in the taxpayer's case the means adopted to achieve the outcome did enlarge the business framework, did provide an enduring benefit and further, that the expenditure achieved more than merely marketing or advertising expenditure. The Commissioner has distinguished the application of the principles on the facts.

Unlike the BP Australia and NAB cases, it could not be said that the advantage sought by the taxpayer was in the nature of marketing. The expenditure outlaid by the taxpayer in a single lump sum payment served to enlarge its operations by absorbing its competitor's market share and obtaining exclusive rights to the IP, and not the process by which it operated to obtain regular returns by regular outlay.

The Commissioner has similarly distinguished the position of the taxpayer from that of Tyco on the basis that in the taxpayer's case, the means adopted was not merely to remunerate an independent sales force. What the taxpayer received for its purchase consideration was not merely an assignment of customers, but the exclusive rights to software to be used in its business.

Conclusion

Taking all of the above factors into consideration, the outgoing incurred by the taxpayer in acquiring the IP is considered to be capital, or of capital nature.

In considering this issue, where the accounting treatment adopted by the taxpayer is not contrary to legal principle, the way the taxpayer records an item in its books of account can be considered a reflection of the character of the expenditure. Whilst not determinative, the accounting treatment may assist in ascertaining its true nature. It forms part of the overall picture which must be considered in determining the correct characterisation of the payments (see Travelodge Papua New Guinea Ltd v. Chief Collector of Taxes (1985) 16 ATR 867; 85 ATC 4432). In this instance, the taxpayer will account separately for the purchase of IP and the purchase of shares. Subsequent to acquisition, it is the intention of the taxpayer to amortise the cost of the IP over a period of five years for accounting purposes. Treatment of the item in this way is not inconsistent with the conclusion that the outgoing is of capital nature.

The conclusion that the outgoing is capital or of a capital nature is supported by the Agreement, the enduring benefit of the transaction and the proposed accounting treatment in the books of the taxpayer.

Question 2

Summary

The taxpayer will be entitled to a deduction under Division 40 in respect of the cost of acquiring the software protected by copyright over the shorter of 25 years or the period until the copyright ends.

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.

The term 'depreciating asset' is defined in subsection 40-30(1) of the ITAA 1997 to mean an asset that has limited effective life and can reasonably be expected to decline in value over the time it is used. Only intangible assets listed in subsection 40-30(2) of the ITAA 1997 can be depreciating assets, one of which is intellectual property.

Pursuant to section 995-1 of the ITAA 1997, intellectual property is an item consisting of the rights that an entity has under a Commonwealth law as including:

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.

The taxpayer acquired all of the software and associated intellectual property rights of the vendor. The acquired software is protected by copyright, which protects certain classes or categories of work including computer programs. For computer programs and most other works, it is not possible for the creator to apply for copyright protection as it automatically exists.

The country in which the copyright exists and Australia are both parties to the Berne Convention. The Berne Convention is an international agreement on copyright by which member countries grant each other copyright protection.

Whilst the acquisition covers all of the vendor's intellectual property, an internal valuation undertaken by the taxpayer concluded that minimal value was to be attributable to the registered intellectual property identified in the annexure to the Agreement. Accordingly, the consideration paid for the IP will almost entirely be attributed to unregistered software intellectual property (copyright).

The copyright works acquired by the taxpayer will be depreciating assets pursuant to paragraph 40-30(2)(c) of the ITAA 1997 providing they are not trading stock. Section 70-10 of the ITAA 1997 defines trading stock as including:

a) anything produced, manufactured or acquired that is held for purposes of manufacture, sale or exchange in the ordinary course of a business; and

b) live stock

Taxation Ruling TR 93/12 Income tax: computer software provides that software held for the purposes of licensing or sub-licensing would not constitute trading stock if the taxpayer is not in the business of marketing software licences. While the ruling deals with licences for software, the application of the principle to copyright works means that the copyright works would not constitute trading stock if the holder of the copyright works is not in the business of marketing copyright works.

The taxpayer is not acquiring the copyright works for the purposes of selling or trading them in the ordinary course of business. The software will be adapted for inclusion within the taxpayer's pool of software intellectual property. It will be used to derive assessable income by exploiting the copyright in the software to derive license fees. Accordingly, the copyright works will be depreciating assets.

Item 5 of the table in subsection 40-95(7) provides that the effective life of Copyright is the shorter of 25 years or the period until the copyright ends.