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Ruling

Subject: Deductions for patent development

Question 1

Are you carrying on a business?

Answer

No

Question 2

Will the Commissioner exercise the discretion in paragraph 35-55(1)(b) of the Income Tax Assessment Act 1997 (ITAA 1997) to allow you to include losses from your activities of developing a patent in your calculation of taxable income for the 2011-12 financial year?

Answer

No

Question 3

Are you entitled to a deduction for the cost of legal fees to defend a challenge to your patent under section 8-1 of the ITAA 1997?

Answer

No

Question 4

Are you entitled to depreciation for the cost associated with developing a patent, including travel and legal fees for patent advice in the 2011-12 financial year?

Answer

No

Question 5

Are you entitled to depreciate the costs associated with developing software applications, such as postage, office expenses, parking, rent, phone calls and travel in the 2011-12 financial year?

Answer

No

This ruling applies for the following period

Year ending 30 June 2012

The scheme commenced on

1 July 2011

Relevant facts

You have lodged a provisional patent application for an invention.

You have incurred expenses related to the initial commercialisation process.

To date you have incurred expenses on legal fees in defending a challenge to your patent and on other general expenses.

You intend to exploit the patent for income-producing purposes. You expect to receive income from the product, possibly in the form of licensing income, from the 2012-13 financial year.

You expect to meet the assessable income test, and make a profit, in the 2013-14 income year.

You attended a training course on commercialising inventions.

You state that the accepted number of years before an activity becomes commercially viable in the industry is 3-5 years.

You have provided a timeline of your activities and a breakdown of expenses you have incurred relating to the activity to date:

Marketing activities have only included market research at this stage, including discussions with people that might use the product.

You do not have a business plan at this stage.

You have plans for other inventions, which you are working on in parallel with this invention.

You have not previously carried on a business relating to the regular creation and commercialisation of inventions.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1
Income Tax Assessment Act 1997 Paragraph 35-55(1)(b)
Income Tax Assessment Act 1997 Subsection 40-25(1)
Income Tax Assessment Act 1997 Section 40-30
Income Tax Assessment Act 1997 Subsection 40-30(1)
Income Tax Assessment Act 1997 Subsection 40-30(2)
Income Tax Assessment Act 1997 Section 40-95
Income Tax Assessment Act 1997 Subsection 40-95(7)
Income Tax Assessment Act 1997 Section 40-175
Income Tax Assessment Act 1997 Section 40-180
Income Tax Assessment Act 1997 Section 40-185
Income Tax Assessment Act 1997 Section 40-190
Income Tax Assessment Act 1997 Section 40-830
Income Tax Assessment Act 1997 Subsection 40-830(3)
Income Tax Assessment Act 1997 Subsection 40-830(4)
Income Tax Assessment Act 1997 Section 40-840
Income Tax Assessment Act 1997 Section 995-1

Reasons for decision

Summary

We do not consider that you are carrying on a business so the non-commercial loss provisions will not apply.

The legal fees incurred by you in defending the patent are of a capital nature and not deductible under section 8-1 of the ITAA 1997. The expenditure was incurred to protect the existence of a future income-earning asset.

A patent cannot be granted from a provisional application as it isn't examined but it gives you 12 months to decide whether you want to pursue standard patent protection.

If you proceed and successfully patent your invention, a depreciating asset will exist and your expenses will form part of the first element of the cost base of that patent under section 40-180 of the ITAA 1997.

If your patent is subsequently used to earn assessable income, you may claim deductions for depreciation over the effective life of your patent from the time you start to use your patent to earn assessable income.

A deduction for the capital expenses incurred in developing a successful patent under Division 40 of the ITAA 1997 is based on an effective life of 20 years.

A deduction for the capital expenses incurred in developing the copyright in a software application under Division 40 of the ITAA 1997 is based on an effective life of 25 years.

Detailed explanation

Carrying on a business and non-commercial losses

The courts have developed a series of indicators that you can apply to your circumstances to determine whether you are carrying on a business. Taxation Ruling TR 97/11 'Income tax: Am I carrying on a business of primary production?' summarises these relevant indicators, as follows:

· whether the activity has a significant commercial purpose or character

· whether the taxpayer has more than just an intention to engage in business

· whether the taxpayer has a purpose of profit as well as a prospect of profit from the activity

· whether there is regularity and repetition of the activity

· whether the activity is of the same kind, and carried on in a similar manner, to that of ordinary trade in that line of business

· whether the activity is planned, organised and carried on in a businesslike manner such that it is described as making a profit

· the size, scale and permanency of the activity, and

· whether the activity is better described as a hobby, a form of recreation or sporting activity.

No one indicator is decisive. The indicators must be considered in combination and as a whole.

In your case, you have invented one product with the intention to commercialise it. You do not have a history of earning assessable income via the regular creation and commercialisation of inventions. The volume of your operations, capital employed, and repetition and regularity of the activities are not consistent with a business and your potential for profit is currently speculative.

In applying the facts of your case to these indicators, the general impression gained is that you are not currently carrying on a business of the creation and commercialisation of inventions.

As you are not carrying on a business, the non-commercial loss provisions under Division 35 of the ITAA 1997 do not apply.

Legal expenses in defending a patent

Section 8-1 of the ITAA 1997 is about general deductions and provides a loss or an outgoing is an allowable deduction if it is incurred in producing assessable income or in carrying on a business for the production of assessable income (the positive limbs) unless that loss or outgoing is capital or of a private or domestic nature or exempt income (the negative limbs).

Legal expenses are generally deductible if they arise out of the day to day activities of your business (Herald and Weekly Times Ltd v. Federal Commissioner of Taxation (1932) 48 CLR 113; (1932) 39 ALR 46; (1932) 2 ATD 169) and the legal action has more than a peripheral connection to your income producing activities (Magna Alloys and Research Pty Ltd v. FC of T (1980) 49 FLR 183; (1980) 11 ATR 276; 80 ATC 4542).

Further, in Smithkline Beecham Laboratories (Australia) Ltd v. FCT (1993) 26 ATR 260 (Smithkline), the taxpayer unsuccessfully claimed deductions for expenses incurred in the course of two legal proceedings. Hill J found that the purpose of the taxpayer in commencing and prosecuting the proceedings was a desire to exclude, so far as possible, competitors from gaining approval of competing products.

It has been established from case law that several relevant factors arise that aid in the distinction between capital and revenue. Firstly, legal fees that are incurred to overcome an obstacle to a taxpayer's day-to-day income-earning activities lend weight to it being revenue expenditure. However, legal fees that are incurred to free a taxpayer from competition, or to protect its monopoly over a significant part of its business, or otherwise imperils the existence of an income-earning activity or the capital structure of the income-earning activity will lend weight to it being capital expenditure.

The legal expenses incurred by you, in defending the claims brought against you in relation to the patent, are not deductible under section 8-1 of the ITAA 1997 because they do not relate to the process of the derivation of your assessable income. Rather, the advantage sought in incurring this expenditure is the potential establishment of a profit-yielding subject, that is, the patent. Thus, the advantage sought in incurring this expenditure is of a capital nature.

Accordingly, the legal fees incurred by you in defending the patent are of a capital nature and not deductible under section 8-1 of the ITAA 1997. The expenditure was incurred to protect the existence of a future income-earning asset.

Deductions for capital assets

You can deduct an amount equal to the decline in value for an income year of a depreciating asset under subsection 40-25(1) of the ITAA 1997. A depreciating asset is, broadly, defined in subsection 40-30(1) as an asset that has a limited effective life and can reasonably be expected to decline in value over the time it is used.

The definition of intellectual property is found within section 995-1 of the ITAA 1997. It includes the rights that an entity has under a Commonwealth Law as:

· the patentee, or a licensee, of a patent or the equivalent rights under a foreign law; or

· as the owner, or licensee of a copyright or the equivalent rights under a foreign law.

An item of intellectual property is a depreciating asset pursuant to the definition of that term in section 40-30 of the ITAA 1997.

The cost of a depreciating asset that a taxpayer holds consists of two elements: namely, the first element of cost and the second element of cost as outlined under section 40-175 of the ITAA 1997.

The first element of cost of a depreciating asset includes all capital amounts paid to hold the depreciating asset and is worked out under section 40-185 of the ITAA 1997.

As the creation of a patent or copyright necessarily entails bringing into existence the subject matter which it protects, the first element of cost of a patent or copyright includes capital amounts incurred directly in creating the subject matter which the patent or copyright protects.

In your case, this will include amounts paid to a patent attorney, travel, postage, parking, phone calls and home office expenses. Home office expenses excludes rent unless you are carrying on a business and it is your place of business, that is, if you run a business from home and an area of the home is set aside exclusively for these business activities.

For Division 40 purposes, second element costs are the capital amounts that are taken to have been paid to bring a depreciating asset to its present condition and location from time to time (section 40-190 of the ITAA 1997).

Section 40-95 of the ITAA 1997 outlines the choices available of determining the effective life for depreciating assets. There is an exception for intangible depreciating assets in subsection 40-95(7) of the ITAA 1997. You do not have the option to determine your own effective life for a patent or copyright as they are prescribed.

The effective life of a standard patent is shown at item 1 in the table as 20 years.

However, you are not entitled to a deduction for decline in value in the 2011-12 financial year. You can claim a deduction from the time that you start to use the patent to earn assessable income.

Software

Part of your invention is software. Taxation Ruling TR 93/12 Income Tax: computer software, looks at the income tax implications arising from the development and marketing of computer software.

Paragraphs 11 and 15 of TR 93/12 outline what a computer program is and the treatment for copyright purposes:

'11. A computer program as distinct from its carrying medium is in essence knowledge or information; it is an item of intellectual property. The carrying medium is tangible property, but the computer program is intangible property. It is strictly not the carrying medium but what is stored on the carrying medium (i.e. the computer program) which constitutes software.'

'15. By the Copyright Amendment Act 1984, assented to on 15 June 1984, The Copyright Act 1968 (Cth) (the Copyright Act) was amended to protect computer software as a literary work and to clarify the nature and scope of that protection having regard to the distinctive features of computer software. The amendments specifically includes computer programs in the existing copyright category of "literary works" and gives to computer programs the protection applied to literary works.'

As a result of the operation of the Copyright Act, you as creator of the software application automatically become the owner of copyright (an intangible asset) to the software applications you have developed. Copyright is not something that you have to 'apply for'.

In your case, the software developed by you is intended to derive assessable income by exploiting the copyright in the application so as to derive licence fees, and not to use the software in your own operations.

The copyright in the software will provide an enduring benefit. Therefore the expenditures directly incurred to develop the content of the applications would be considered of a capital nature.

The effective life of copyright is shown at item 5 in the table in subsection 40-95(7) of the ITAA 1997 as the shorter of 25 years or the period until the copyright ends.

Therefore, a deduction is not allowable under section 8-1 of the ITAA 1997 for the cost of developing the applications, but you will be able to claim a deduction for the capital expenses incurred in developing the copyright in the software under Division 40 of the ITAA 1997 based on an effective life of 25 years.

However, you are not entitled to a deduction for decline in value in the 2011-12 financial year. You can claim a deduction from the time that you start to use the copyright to earn assessable income.