Edited version of your written advice

Authorisation Number: 1012926239009

Date of advice: 16 December 2015

Ruling

Subject: Disposal of R&D results

Question 1

Is the Closing Payment paid as part of the Purchase Price under the Asset Purchase Agreement (APA) received by the Vendor for the disposal of IP Assets under the APA included in the Vendor's assessable income solely under subsection 355-410(2) of the ITAA 1997 in the income year in which the APA is executed?

Answer

Yes.

Question 2

Is the Escrow Amount paid as part of the Purchase Price under the APA received by the Vendor for the disposal of IP Assets under the APA included in the Vendor's assessable income solely under subsection 355-410(2) of the ITAA 1997 in the income year in which the APA is executed?

Answer

No.

Question 3

Is each specific Milestone Payment paid as part of the Purchase Price under the APA received by the Vendor for the disposal of IP Assets under the APA included in the Vendor's assessable income solely under subsection 355-410(2) of the ITAA 1997 in the income year in which the Vendor receives, or becomes entitled to receive the Milestone Payment?

Answer

Yes.

Question 4

If the Purchase Price received (being the Closing Payment, Escrow Amount and each specific Milestone Payment) is included in assessable income under subsection 355-410(2) of the ITAA 1997 in the current (or any future) year of income, will any other provision of the income tax law, apart from any anti-avoidance or integrity provision which may apply, include any amount in the Vendor's assessable income in the current (or any future) year of income?

Answer

Yes.

This ruling applies for the following periods:

v 1 July 2015 - 30 June 2016

v 1 July 2016 - 30 June 2017

v 1 July 2017 - 30 June 2018

Relevant facts and circumstances

The Vendor is an Australian private company, which was incorporated around the year 2000. The Vendor is the developer of Intellectual Property (IP) which has application in the health industry. The IP has been used successfully in two pivotal Phase 3 clinical studies.

The Vendor has filed a New Drug Application with the United States Food and Drug Administration (FDA). The Vendor's principal activity is research and development (R&D).

The Vendor has registered activities under the Industry Research and Development Act 1986 (Project) for the income years ending:

• 30 June 2011

• 30 June 2012

• 30 June 2013

• 30 June 2014

• 30 June 2015

Since commencing operations in early 2000, being the development of IP in relation to the Project through R&D activities, the Vendor has experienced recurring net losses and negative cash flows from operations.

The Vendor has not made an election to be subject to the Taxation of Financial Arrangement (TOFA) rules set out in Division 230 of the ITAA 1997, and falls within the exception detailed in subsection 230-455(4) of the ITAA 1997.

Transaction

To realise the value of the IP which the Vendor wishes to dispose of, it has determined to realise the value of the company via the sale of its assets. The Vendor has entered into the APA with the Purchaser.

The APA provides for the Vendor to sell its exclusive rights to IP and other rights and obligations in relation to its product developed from the Project.

The IP Assets to be disposed effectively represent 100% of the value of the existing business.

The Purchaser will assume and thereafter pay specified liabilities relating to the business or use of the assets transferred as part of the Transaction under the APA; however, this does not include liabilities attributable to taxes, liabilities to affiliates of the Vendor and liabilities arising from the Transaction.

The Vendor is entitled to receive the following payments:

1. Closing Purchase Price, payable on execution of the APA

2. Escrow Payment, payable in 18 months' time, subject to certain conditions

3. Nine subsequent Milestone Payments, subject to regulatory approvals and achievement of net sales figures by the Purchaser

The Vendor has entered into a licence agreement whereby the Vendor is granted a right to use the IP Assets in certain territories outside of the US.

The value of this licence arrangement represents less than 10% of the overall value of the IP Assets disposed of. The APA does not attribute a value to any particular asset (nor does it break down the value according to categories of R&D expenditure).

R&D Activities and Expenditure

In relation to the R&D activities and expenditure:

• the value of the IP Assets being disposed of has been generated due to R&D conducted under the R&D tax incentive. This is on the basis that although the R&D activities undertaken by the company span across both the section 73B of the Income Tax Assessment Act 1936 (ITAA 1936), and Division 355 of the Income Tax Assessment Act 1997 (ITAA 1997), the value of the associated IP, and other R&D results arising from the Project, was realised by R&D activities undertaken for which expenditure was claimed under the R&D tax incentive as provided under Division 355 of the ITAA 1997.

• the transaction could not have been realised without proving the clinical efficacy of the IP. This is further supported by the business development efforts to secure co-development, investment and commercialisation partnerships, performed by a financial advisor to the Vendor, which indicated the data that the Vendor had compiled up to 2012 was insufficient to secure interest in potential partnership for co-development of the project.

• this is further evidenced by the fact that Phase 3 trial data was required to secure partnership interest (Phase 3 trials being the main focus of the R&D activities conducted under the Division 355 of the ITAA 1997).

Vendor has made claims under the former R&D tax concession, and the current R&D tax incentive in respect of expenditure related to R&D activities associated with the Project.

Relevant legislative provisions

Industry Research and Development Act 1986 Former section 39J

Industry Research and Development Act 1986 section 27A

Income Tax Assessment Act 1936 Former section 25A

Income Tax Assessment Act 1936 Former section 73B

Income Tax Assessment Act 1936 Former subsection 73B(27A)

Income Tax Assessment Act 1936 Former subsection 73B(27B)

Income Tax Assessment Act 1936 Former subsection 73B(27C)

Income Tax Assessment Act 1997 section 6-1

Income Tax Assessment Act 1997 subsection 6-1(5)

Income Tax Assessment Act 1997 section 6-5

Income Tax Assessment Act 1997 subsection 6-5(1)

Income Tax Assessment Act 1997 subsection 6-5(4)

Income Tax Assessment Act 1997 section 6-10

Income Tax Assessment Act 1997 subsection 6-10(3)

Income Tax Assessment Act 1997 subsection 6-25(1)

Income Tax Assessment Act 1997 subsection 6-25(2)

Income Tax Assessment Act 1997 section 15-15

Income Tax Assessment Act 1997 paragraph 15-15(2)(b)

Income Tax Assessment Act 1997 Division 40

Income Tax Assessment Act 1997 Subdivision 40-C

Income Tax Assessment Act 1997 section 40-25

Income Tax Assessment Act 1997 subsection 40-25(2)

Income Tax Assessment Act 1997 subsection 40-25(7)

Income Tax Assessment Act 1997 section 40-30

Income Tax Assessment Act 1997 subsection 100-20(1)

Income Tax Assessment Act 1997 section 102-5

Income Tax Assessment Act 1997 subsection 102-5(1)

Income Tax Assessment Act 1997 paragraph 104-10(3)(a)

Income Tax Assessment Act 1997 section 108-5

Income Tax Assessment Act 1997 subsection 108-5(1)

Income Tax Assessment Act 1997 Subdivision 118-A

Income Tax Assessment Act 1997 section 118-20

Income Tax Assessment Act 1997 paragraph 118-20(1)(a)

Income Tax Assessment Act 1997 section 118-24

Income Tax Assessment Act 1997 subsection 118-24(1)

Income Tax Assessment Act 1997 paragraph 118-24(1)(a)

Income Tax Assessment Act 1997 section 118-35

Income Tax Assessment Act 1997 Division 230

Income Tax Assessment Act 1997 section 230-20

Income Tax Assessment Act 1997 subsection 230-20(4)

Income Tax Assessment Act 1997 subsection 230-45(2)

Income Tax Assessment Act 1997 subsection 230-455(4)

Income Tax Assessment Act 1997 Division 355

Income Tax Assessment Act 1997 section 355-100

Income Tax Assessment Act 1997 paragraph 355-25(2)(e)

Income Tax Assessment Act 1997 paragraph 355-100(1)(b)

Income Tax Assessment Act 1997 section 355-305

Income Tax Assessment Act 1997 section 355-410

Income Tax Assessment Act 1997 paragraph 355-410(1)(b)

Income Tax Assessment Act 1997 subparagraph 355-410(1)(b)(i)

Income Tax Assessment Act 1997 subparagraph 355-410(1)(b)(ii)

Income Tax Assessment Act 1997 subparagraph 355-410(1)(b)(iii)

Income Tax Assessment Act 1997 subparagraph 355-410(1)(b)(iv)

Income Tax Assessment Act 1997 subparagraph 355-410(1)(b)(v)

Income Tax Assessment Act 1997 subsection 355-410(2)

Income Tax Assessment Act 1997 section 355-715

Income Tax Assessment Act 1997 Division 775

Income Tax Assessment Act 1997 section 775-5

Income Tax Assessment Act 1997 subsection 775-15(1)

Income Tax Assessment Act 1997 subsection 775-30(1)

Income Tax Assessment Act 1997 subsection 775-45(1)

Income Tax Assessment Act 1997 subsection 775-45(2)

Income Tax Assessment Act 1997 subsection 775-45(3)

Income Tax Assessment Act 1997 subsection 775-45(4)

Income Tax Assessment Act 1997 subsection 775-45(7)

Income Tax Assessment Act 1997 section 775-85

Income Tax Assessment Act 1997 subsection 775-105(1)

Income Tax Assessment Act 1997 subsection 775-105(2)

Income Tax Assessment Act 1997 subsection 775-135(2)

Income Tax Assessment Act 1997 subsection 960-50

Income Tax Assessment Act 1997 subsection 960-50(6)

Income Tax Assessment Act 1997 subsection 995-1(1)

Reasons for decision

Question 1

Is the Closing Payment paid as part of the Purchase Price under the APA received by the Vendor for the disposal of IP Assets under the APA included in the Vendor's assessable income solely under subsection 355-410(2) of the ITAA 1997 in the income year in which the APA is executed?

Ordinary Income

Is the profit from the disposal of IP Assets ordinary income?

As explained in section 6-1, an amount of assessable income received by a taxpayer will have its basis as either:

• ordinary income (section 6-5), or

• statutory income (section 6-10)

An amount which is ordinary income cannot also be statutory income, and vice versa (see, subsection 6-1(5)).

For the sale of the Vendor's IP Assets to constitute ordinary income it would need to be income according to ordinary concepts (subsection 6-5(1)). The concept of what is income according to ordinary concepts is not free from difficulty, but generally it is expected that the receipt will have characteristics such as periodicity, recurrence and regularity (see, the Full High Court decision in FC of T v Dixon (1952) 86 CLR 540; 10 ATD 82). The notion of income according to ordinary concepts was arguably broadened by the High Court in FC of T v The Myer Emporium Ltd (1987) 163 CLR 199; 87 ATC 4363 (Myer), where a lump sum receipt from an isolated transaction was assessed as ordinary income (under subsection 25(1) of the ITAA 1936) as a profit resulting from a profit making scheme.

Prior to the decision in Myer, and the introduction of a comprehensive capital gains tax regime in Australia, the jurisprudence from both the United Kingdom and Australian courts in relation to the income tax consequences of dealings in 'know how' and IP was far from certain, and the Australian cases in particular, are limited in number.

As explained at [19-400] of the CCH Federal Income Tax Reporter (FITR):

A lump sum amount received for the sale of secret knowledge or processes (i.e. "know-how'') may be a receipt of capital or income, depending on the circumstances of the case. This issue has arisen in a number of cases in the UK and the principles laid down in those cases appear to be determinative of the position in Australia.

The problem has been whether, on the facts, the recipient has parted with something or restricted its operation in some way, or whether it has merely exploited its know-how in the course of carrying on its business. (emphasis added)

However, the commentary referred to above [at 19-400] in the FITR is commenting in relation to 'know how' as opposed to a statutorily recognised (and protected) intellectual property right such as a copyright, trade-mark, registered design or patent.

The assets being disposed of by the Vendor constitute an amalgamation of 'know how' and other property. Whilst some of these IP Assets will be IP as defined by section 995-1, some will not.

In Case W10, 89 ATC 182 an Australian company that dealt in the development of veterinary products developed an uncontaminated breeding stock of a particular species. In order to ensure the preservation of the stock from contamination or disease it entered into a contract with an international firm, which would also maintain this particular species in another jurisdiction. If either source became contaminated each could draw on the other to 'purify' their stock. The Australian company was paid a lump sum amount for the supply of its expertise and technical knowledge. The Commissioner assessed the taxpayer on the basis that the sum was ordinary income and as a royalty.

In upholding the Commissioner's assessment, the AAT considered the dicta of Lord Denning in Evans Medical Supplies Ltd v Moriarty (1957) 37 TC 540 (at 186), and found that the taxpayer did not come within the scope of the reasoning in Evans Medical Supplies and that the transaction - even though isolated - constituted assessable income according to ordinary concepts.

Conversely, in Kwikspan Purlin System Pty Ltd v FC of T 84 ATC 4282, the taxpayer (a company) owned a patented system. The taxpayer received lump sum payments for granting several companies the exclusive right to use the system in different parts of Australia.

The Queensland Supreme Court held that the taxpayer was not in the business of dealing in patents, and the lump sum payments were merely capital receipts resulting from the realisation of an asset.

As discussed previously, Myer determined that where the taxpayer is carrying on a business, and the circumstances give rise to an inference that the taxpayer's intention was to profit, the profit will be income even if the transaction was extraordinary judged by reference to the ordinary course of the taxpayer's business.

The fact that such a 'gain is made as the result of an isolated venture or a "one-off" transaction' does not preclude it from being properly characterised as income.

The current section 15-15 was previously embodied in section 25A of the ITAA 1936. Section 25A provided that where a taxpayer sells property acquired before 20 September 1985 under a profit making scheme that profit will assessable under section 25A of the ITAA 1936. The provision provided that the assessable income of a taxpayer shall include profit arising from:

• the sale of any property acquired for the purpose of profit making by sale; or

• the carrying on of any profit making undertaking or scheme.

Section 15-15 does not apply to a profit that constitutes ordinary income under section 6-5 or profit that arises in respect of the sale of property acquired on or after 20 September 1985.

In other words, if the Commissioner were to regard the profit which arises as a consequence of the disposal of the Vendor's IP Assets as the result of a profit making undertaking or plan (in the form of the entire R&D project), paragraph 15-15(2)(b) specifically excludes any profit from that disposal being included in assessable income on that basis.

Consequently, whilst the disposal of the IP Assets by the Vendor could constitute, or result from, a profit making undertaking or plan - the profit from the disposal would not be characterised as income according to ordinary concepts.

Capital Gains Tax

Having determined that the profit from the sale of IP Assets is not ordinary income, the other basis for inclusion in assessable income is via specific statutory provision, that is, as statutory income.

The primary regime under which an amount received by a taxpayer will be included in their assessable income (i.e., statutory income) is the capital gains tax (CGT) regime set out in Chapter 3 of the ITAA 1997.

The starting point for the application of the CGT provisions in Part 3-1 to 3-3 is identifying what a CGT asset is. Section 108-5 defines what a capital gains tax asset is, relevantly, subsection 108-5(1) provides:

A CGT asset is:

(a) any kind of property; or

(b) a legal or equitable right that is not property.

The IP Assets disposed of by the Vendor in accordance with the APA fall under the broad category of IP rights, but also include trademarks and know-how. It is evident that the IP Assets disposed of will be CGT assets (as defined).

Has a CGT Event occurred?

Subsection 100-20(1) stipulates that you only make a capital gain or loss if a CGT event happens. The disposal of the IP Assets by the Vendor will trigger CGT event A1 (see paragraph 104-10(3)(a)), as there will be a change in the legal and beneficial ownership of the IP Assets. The time the CGT Event happens will be the time when the contract to dispose of those assets is entered into (see paragraph 104-10(3)(a)).

Does the Vendor include any net capital gain in its assessable income?

Subsection 102-5(1) provides that your assessable income includes any net capital gain for the income year. Consequently, in the absence of any exception or exemption, the Vendor will need to include the net capital gain from the disposal of its IP Assets.

Depreciating Assets

Intellectual Property, CGT and Capital Allowances - Acquired Assets

The definition of a CGT asset is very broad, and will include other more specific definitions within the scope of that definition. Of primary significance to the Vendor's position is the statutory definition of intellectual property which is set out in section 995-1, that term is defined as:

an item of intellectual property consists of the rights (including equitable rights) that an entity has under a *Commonwealth law as:

(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.

Division 40 sets out entitlement to deductions for certain types of capital expenditure. In particular, section 40-30 states:

(1) A depreciating asset is an asset that has a limited *effective life and can reasonably be expected to decline in value over the time it is used, except:

(c) an intangible asset, unless it is mentioned in subsection (2).

(2) These intangible assets are depreciating assets if they are not *trading stock:

(c) items of *intellectual property;

However, to be entitled to a deduction for the cost of a depreciating asset during an income year section 40-25 sets out certain requirements. Subsection 40-25(2) provides that any deduction must be reduced to the extent that the asset is not used for a taxable purpose. Subsection 40-25(7) states that a taxable purpose is:

(a) the *purpose of producing assessable income; or

…

Note 2 to subsection 40-25(7) states:

When this Division notionally applies under section 355-310 (about depreciating assets used for R&D activities), the taxable purpose is sometimes only the purpose of conducting R&D activities.

It should be noted that entitlement to a notional deduction under paragraph 355-100(1)(b) only arises in relation to tangible depreciating assets. Therefore, any entitlement to a deduction for acquired IP will only arise upon satisfaction of the requirements of Division 40.

As the Vendor's activities are not being carried out for an ordinary taxable purpose under Division 40 (they are not being carried out for the purpose of producing assessable income), nor do they satisfy section 355-305 (see, paragraph 355-305(1)(b)), any IP acquired by the Vendor which is disposed of under the APA will not give rise to a balancing adjustment event.

This means that the anti-overlap provision, subsection 118-24(1), has no application. Consequently, the disposal of acquired IP by Vendor would be taken into account via the general CGT provisions (CGT event A1).

Intellectual Property, CGT and Capital Allowances - Internally Generated Assets

R&D expenditure incurred by the Vendor in the creation of IP, for example a patent, will generally have been deducted under Division 355 (such as researcher salaries). Expenditure that has been notionally deducted (under Division 355) cannot be taken into account in working out a deduction under any other Division of the Act (see section 355-715).

Some expenditure associated with the generation of IP such as a patent is specifically excluded from being deducted under Division 355 (see paragraph 355-25(2)(e)). Expenditure that is specifically excluded from deduction under Division 355 will form part of the cost of such an asset for the purposes of Subdivision 40-C.

This means that internally generated assets which are IP (such as patents), will only be taken into account under Division 40 once they are held for a taxable purpose (see paragraph 40-25(7)(a)). Further, the tax cost of such assets will be limited to specific costs associated with the creation of the patent (such as registration costs, legal fees).

As the Vendor does not hold these assets for such a purpose, and they are intangible assets which are not eligible to have their cost notionally deducted under Division 355, the disposal of internally generated assets will be subject to the general CGT provisions. That is, the disposal of internally generated IP by the Vendor would be taken into account via the general CGT provisions (CGT event A1).

Anti-overlap provisions

Subdivision 118-A is entitled 'General exemptions', and contains the anti-overlap provisions. There are a number of the anti-overlap provisions that could have application in determining how much (if any) capital gain is included in Vendor's assessable income. The relevant ones are:

• section 118-20 (Reducing capital gains if amount otherwise assessable)

• section 118-24 (Depreciating assets), and

• section 118-35 (R&D)

Exemption - Section 118-20

Paragraph 118-20(1)(a) provides:

(1) A *capital gain you make from a *CGT event is reduced if, because of the event, a provision of this Act (outside of this Part) includes an amount (for any income year) in:

(a) your assessable income or *exempt income; …

The provision only provides for a reduction in the capital gain that is to be included in a taxpayer's assessable income. Therefore, the Vendor would still be required to include a capital gain in its assessable income if no other provision of the Act (outside of Part 3) included an amount in assessable income. Further, the provision also leaves open the operation of the CGT provisions if that other provision does not fully include that relevant amount in the Vendor's assessable income.

Exemption - Section 118-24

Paragraph 118-24(a) provides:

(1) A *capital gain or *capital loss you make from a *CGT event (that is also a *balancing adjustment event) that happens to a *depreciating asset is disregarded if the asset was:

(a) an asset you *held; …

As discussed under the heading 'Depreciating Assets', this specific provision will not operate in relation to the disposal of any of the Vendor's IP Assets which are either acquired depreciating assets, or internally generated depreciating assets.

Exemption - Section 118-35

Section 118-35 allows a taxpayer to disregard a capital gain or loss where the amount included is included in assessable income under section 355-410. The section provides:

Disregard a *capital gain or *capital loss from a *CGT event if an amount is included in your assessable income in any income year under section 355-410 (about disposal of R&D results) because of that CGT event.

Disposal of R&D results

Section 355-410 provides that where an entity (which is an R&D entity) is entitled to a tax offset under section 355-100 because it can deduct expenditure under Division 355, and that entity receives (or becomes entitled to receive) an amount which has resulted from any of the ways identified in subparagraphs 355-410(1)(b)(i)-(v) then that amount is included in the R&D entity's assessable income. Section 355-410 provides:

(1) This section applies to an *R&D entity if:

(a) the R&D entity is entitled under section 355-100 to a *tax offset because it can:

(i) deduct under section 355-205 or 355-480 expenditure incurred on *R&D activities; or

(ii) deduct under section 355-305 or 355-520 an amount for an asset (the R&D asset) used for the purpose of conducting one or more R&D activities; and

(b) the R&D entity receives or becomes entitled to receive one or more of the following amounts (the results amounts) in an income year (the results year):

(i) an amount for the results of any of the R&D activities;

(ii) an amount from granting access to, or the right to use, any of those results;

(iii) an amount attributable to the R&D entity having incurred the expenditure, including an amount it is entitled to receive regardless of the results of the R&D activities;

(iv) an amount attributable to the R&D asset being used for the purpose mentioned in subparagraph (a)(ii), including an amount the R&D entity is entitled to receive regardless of the results of the R&D activities;

(v) an amount from *disposing of a *CGT asset, or from granting a right to occupy or use a CGT asset, where the disposal or grant resulted in another person acquiring a right to access or use any of those results.

Note: This section also applies with changes to the partners of an R&D partnership (see section 355-535).

(2) For each results amount, the following amount is included in the *R&D entity's assessable income for the results year:

(a) if the results amount is only a results amount because of subparagraph (1)(b)(v), and the asset referred to in that subparagraph is a *depreciating asset-an amount equal to the extent (if any) that the results amount exceeds the asset's *cost just before the disposal or grant;

(b) if the results amount is only a results amount because of subparagraph (1)(b)(v), and the asset referred to in that subparagraph is not a depreciating asset-an amount equal to the extent (if any) that the results amount exceeds the asset's *cost base just before the disposal or grant;

(c) otherwise-the results amount.

(3) For the purposes of paragraph (2)(a), assume that subsection 40-45(2) did not, except in the case of buildings and extensions, alterations and improvements to buildings, prevent Division 40 from applying to certain capital works.

The Commissioner has determined that the disposal of the Vendor's IP Assets will not be ordinary income. Further, the Commissioner has determined that the disposal will not give rise to a balancing adjustment event under Division 40, upon which the exemption under section 118-24 would otherwise operate.

This leaves the Commissioner to determine if the entire Closing Payment is brought into Vendor's assessable income solely under subsection 355-410(2) or under a combination of provisions.

As explained in ATO Interpretative Decision ATO ID 2015/4:

… section 355-410 is an integrity provision which corresponds to the former integrity rules in subsections 73B(27A), 73B(27B) and 73B(27C) of the ITAA 1936. The role of these provisions is to ensure statutory revenue treatment for amounts received by an R&D entity relating to the results of R&D activities, including from the granting of rights to the results by way of licensing.

Section 355-410 operates to include certain amounts (referred to as 'results amounts') an R&D entity receives or is entitled to receive in an income year in the R&D entity's assessable income for that year.

However, ATO ID 2015/4 concerned a taxpayer who received 'results amounts', some of which were referrable to R&D activities for which it had incurred expenditure on, and claimed a tax offset under Division 355, and some of which it had not.

In ATO ID 2015/4 the Commissioner makes it clear that

… where the disposal or right to access the results of R&D activities and non-R&D activities are conveyed under a single agreement for a lump sum payment, they need to be considered as separate matters for the purposes of applying section 355-410 of the ITAA 1997. Only the portion of the lump sum attributable to the disposal of the R&D results will be included as assessable income under section 355-410 of the ITAA 1997 as a results amount.

It will be a question of fact as to what portion of a composite lump sum received is attributable to the disposal of R&D results, having regard to the terms of the relevant contract or agreement…

Unlike the circumstances in ATO ID 2015/4, whilst the Closing Payment made to the Vendor for the disposal of its IP Assets is a lump sum made under a single agreement - it is not a composite lump sum.

That is, the Commissioner accepts the Vendor's contention that the Closing Payment made for the IP Assets will be included in the Vendor's assessable income under subsection 355-410(2). As such section 118-35 operates to disregard any capital gain of the Vendor from the disposal of IP Assets as the amount is included in assessable income under section 355-410. The relevant results amounts arise as a consequence of subparagraphs in paragraph 355-410(1)(b):

Patent Applications

When the Vendor receives (or becomes entitled to receive) that amount of the Closing Payment that relates to a Patent Application (or Applications), the Commissioner is satisfied that the Vendor has received an amount in accordance with subparagraph 355-410(1)(b)(i).

This is on the basis that a patent application is directly related to expenditure on R&D activities for which the Vendor claimed a notional deduction for expenditure which gave rise to an R&D tax offset.

Patents

When the Vendor receives (or becomes entitled to receive) that amount of the Closing Payment that relates to a Patent (or Patents), the Commissioner is satisfied that the Vendor has received an amount in accordance with subparagraph 355-410(1)(b)(v).

This is on the basis that a patent is directly related to expenditure on R&D activities for which the Vendor claimed a notional deduction for expenditure which gave rise to an R&D tax offset.

Trademarks

When the Vendor receives (or becomes entitled to receive) that amount of the Closing Payment that relates to Trademarks, the Commissioner is satisfied that the Vendor has received an amount in accordance with subparagraph 355-410(1)(b)(v).

A Trademark is a CGT asset as defined in subsection 108-5(1). Whilst the acquisition of a particular Trademark is not necessarily required to access the results of the R&D activities, ownership of this Trademark is necessary to use (that is, exploit) the results of those R&D activities.

Contracts

When the Vendor receives (or becomes entitled to receive) that amount of the Closing Payment that relates to Contracts, the Commissioner is satisfied that the Vendor has received an amount in accordance with subparagraph 355-410(1)(b)(v).

The Contracts are CGT assets as defined in subsection 108-5(1). The assignment of these contracts is essential in order to use (that is, exploit) the results of those R&D activities which have been acquired by the Purchaser.

Regulatory Matters

When the Vendor receives (or becomes entitled to receive) that amount of the Closing Payment that relates to Regulatory Matters, the Commissioner is satisfied that the Vendor has received an amount in accordance with subparagraph 355-410(1)(b)(v).

The Regulatory Matters are CGT assets as defined in subsection 108-5(1). These rights must be created in the Purchaser in order to use (that is, exploit) the results of those R&D activities that have been acquired.

Question 2

Is the Escrow Amount paid as part of the Purchase Price under the APA received by the Vendor for the disposal of IP Assets under the APA included in the Vendor's assessable income solely under subsection 355-410(2) of the ITAA 1997 in the income year in which the APA is executed?

For the same reasons that the Closing Payment discussed in question 1 was determined to be statutory income, which is assessable to the Vendor under subsection 355-410(2), so to the Escrow Amount is characterised as statutory income and is assessable to the Vendor under subsection 355-410(2).

A taxpayer is generally taken to have 'derived' an amount of ordinary income as soon as it is applied or dealt with in any way on the taxpayer's behalf, or as the taxpayer directs (subsection 6-5(4)). That is the taxpayer is taken to have received the amount as soon as they get the benefit from it.

As amounts included in assessable income under subsection 355-410(2) are statutory income, the equivalent provision in Division 6 is subsection 6-10(3), which provides:

If an amount would be *statutory income apart from the fact that you have not received it, it becomes statutory income as soon as it is applied or dealt with in any way on your behalf or as you direct.

For taxpayers who return income on an accruals or earnings basis, an amount is derived when it becomes due to the taxpayer; actual receipt is not required.

However, paragraph 355-410(1)(b) provides:

the R&D entity receives or becomes entitled to receive one or more of the following amounts (the results amounts) in an income year (the results year)

In determining when a results amount is included in assessable income, subsection 355-410(2) provides:

For each results amount, the following amount is included in the *R&D entity's assessable income for the results year:

…

Accordingly, the Escrow Amount will be included in the Vendor's assessable income in the income year which Vendor 'receives or becomes entitled to receive' the amount.

As discussed in ATO ID 2004/568:

The ordinary meaning of 'becoming entitled to receive an amount' is that there is an absolute or unconditional entitlement to receive the amount. Part of the entry for 'entitle' in the The Macquarie Dictionary , 2001 rev. 3rd edn., The Macquarie Library Pty Ltd, NSW is:

   ... furnish with grounds for laying claim.

Similarly, part of the entry for 'entitle' in Black's Law Dictionary , Black, HC, 1991, Abridged 6th edn., West Pub. Co, St Paul:

   ...To qualify for, to furnish with proper grounds for seeking or claiming

The earliest point in time that Vendor will become entitled to the Escrow Amount is 18 months after the APA is executed.

Consequently, the Vendor will only be entitled to the balance of the Escrow Amount after this point in time.

Question 3

Is each specific Milestone Payment paid as part of the Purchase Price under the APA received by the Vendor for the disposal of IP Assets under the APA included in the Vendor's assessable income solely under subsection 355-410(2) of the ITAA 1997 in the income year in which the Vendor receives, or becomes entitled to receive the Milestone Payment?

For the same reasons that the Closing Payment discussed in question 1 was determined to be statutory income and assessable to the Vendor under subsection 355-410(2), so too will each Milestone Payment will be statutory income and assessable to the Vendor under subsection 355-410(2).

Unlike the position of the licensee discussed in ATO ID 2015/5, the nine Milestone Payments that are to be made by the Purchaser relate directly to the disposal of the R&D results (namely, the product IP and any related know-how). These payments are required to be made by the Purchaser to the Vendor for the acquisition of the IP Assets (R&D results).

The Vendor's right to receive the various Milestone Payments is subject to further successful development of the R&D results by the Purchaser, in the form of regulatory approvals and attainments of set nett sales amounts.

Accordingly these amounts fall within the scope of section 355-410 as a 'results amount' because they are 'an amount for the results of any of the R&D activities'.

It is clear from the words in section 355-410 that for its operation, what is required is for the R&D entity to be entitled to the notional deduction and tax offset in respect of the expenditure incurred in developing the R&D results. Once this condition is met, the provision operates to assess the entire amount received (or entitled to be received) by the R&D entity, on disposal of those results, as an R&D 'results amount.'

Section 355-410 does not put a time limit on how long, or the manner in which, the R&D results should be used. All that is required is that the amount is received (or entitled to be received):

• for the results of any of the R&D activities, or

• from the grant of access to, or the right to use, any of those results.

The terms 'for' and 'from' in section 355-410 are sufficiently broad to encompass future payments by a Purchaser, which are contingent upon (or subject to) specific conditions as set out in the contractual documents which provide for the disposal of the R&D results.

The Vendor is entitled to receive the Milestone Payments upon the achievement of each Milestone by the Purchaser. Therefore, the Vendor is required to include in its assessable income, under section 355-410, the Milestone Payments in the income year in which the Purchaser satisfies those conditions. This is consistent with the view in ATO ID 2004/568 discussed earlier.

Question 4

If the Purchase Price received (being the Closing Payment, Escrow Amount and each specific Milestone Payment) is included in assessable income under subsection 355-410(2) of the ITAA 1997 in the current (or any future) year of income will any other provision of the income tax law, apart from any anti-avoidance or integrity provision which may apply, include any amount in the Vendor's assessable income in the current (or any future) year of income?

The Vendor has not made an election to be subject to the Taxation of Financial Arrangement (TOFA) rules set out in Division 230, and falls within the exception detailed in subsection 230-455(4). Were the gain from the disposal of the Vendor's IP Assets subject to Division 230, then section 230-20 would ensure that this gain would not be brought into the Vendor's assessable income under any other provision of the Act (see, subsection 230-20(4)).

As explained in questions 1, 2 and 3, the Purchase Price which consists of the Closing Payment, Escrow Amount and Milestone Payments are all statutory income and assessable to Vendor under subsection 355-410(2), in the income year that the Vendor receives, or becomes entitled to receive the particular payment.

Further, subsection 6-25(1) ensures that such amount is only included in the Vendor's assessable income once.

However, the APA is expressed in $USD, and Division 775 operates to include in assessable income or allow as a deduction, a forex realisation gain or loss which results from a forex realisation event (FRE) happening. Section 775-5 provides the 5 main types of FREs that are dealt with under Division 775.

Having regard to the terms of the APA, it is considered that FRE 2 is the relevant FRE.

Subsection 775-45(1) provides as follows:

Forex realisation event 2 happens if:

(a) you cease to have a right, or a part of a right, to receive *foreign currency; and

(b) the right, or the part of the right, is one of the following:

(i) a right, or a part of a right, to receive, or that represents, *ordinary income or *statutory income (other than statutory income that is assessable under this Division or Division 102);

…

Foreign currency is defined in subsection 995-1(1) to mean a currency other than Australian currency.

Under the terms of the APA, the consideration payable to the Vendor will be made over a maximum of 9 payments.

Whilst the term 'right' is not defined in Division 775, paragraph 2.58 of the Explanatory Memorandum to the New Business Tax System (Taxation of Financial Arrangements) Bill (No. 1) 2003 states that it is intended to carry its ordinary legal meaning. The Macquarie Dictionary, 2001 rev. 3rd Edn., The Macquarie Library Pty Ltd, NSW defines a right as:

… a just claim or title, whether legal, prescriptive, or moral; that which is due to anyone by just claim.

Under the terms of the APA, the Vendor obtains a right to receive foreign currency at a certain time at each of those 9 possible Milestones.

Pursuant to subsection 775-45(2), FRE 2 will happen at the time of each payment by the Purchaser.

Under the arrangement, when the Vendor receives a payment in accordance with the APA, FRE 2 will happen because it will cease to have a right to receive foreign currency. As discussed above in questions 1 to 3, these payments will be treated as statutory income under section 355-410.

Forex realisation gain or forex realisation loss

When the Vendor receives a payment in accordance with the APA, the receipt may result in a forex realisation gain (subsection 775-45(3)) or a forex realisation loss (subsection 775-45(4)) to the extent that such gain or loss is attributable to a currency exchange rate effect.

A currency exchange rate effect is defined in subsection 775-105(1) as:

(a) any currency exchange rate fluctuations; or

(b) a difference between:

(i) an expressly or implicitly agreed currency exchange rate for a future date or time; and

(ii) the applicable currency exchange rate at that date or time.

To determine whether there is a currency exchange rate effect, the translation rules in section 960-50 apply (subsection 775-105(2)). Section 960-50 provides a standard translation rule for the translation of all foreign currency denominated amounts to Australian Dollar (AUD) and requires that foreign currency denominated amounts be translated to AUD at specific times.

To establish whether the Vendor makes a forex realisation gain or forex realisation loss, subsections 775-45(3) and 775-45(4) require a comparison to be made between the AUD equivalent of:

(1) the amount received in respect of the event happening; and

(2) the forex cost base (see, section 775-85) of the right or the part of the right (translated at the tax recognition time provided in the table in subsection 775-45(7)).

Item 1 of the table in subsection 775-45(7) provides that the tax recognition time for a right to statutory income is when the requirement first arose to include the statutory income in the Vendor's assessable income.

The forex cost base of a right (or part thereof) to receive foreign currency is defined in section 775-85 as the total of money paid (or required to pay) and the market value of non-cash benefits provided (or required to provide) in respect of acquiring the right, reduced by any amount that is deductible under the Act (other than under Division 775).

Accordingly, whether the Vendor makes a forex realisation gain or loss requires a comparison of the AUD equivalent of the amount received translated at the exchange rate applicable at the time when the Vendor ceases to have the right to receive foreign currency (subsection 960-50(6) item 11) and the forex cost base translated at the exchange rate applicable at the time when the requirement first arose to include it in the Vendor's assessable income (subsection 960-50(6) item 7).

Where the amount in (1) above exceeds the amount in (2) above, so much of the excess that is attributable to a currency exchange rate effect is a forex realisation gain. Pursuant to subsection 775-15(1), the Vendor will be required to include the forex realisation gain in its assessable income in the income year in which FRE 2 happens.

Conversely, where the amount in (1) above falls short of the amount in (2) above, so much of the short fall that is attributable to a currency exchange rate effect is a forex realisation loss. Pursuant to subsection 775-30(1), the Vendor can deduct the forex realisation loss from its assessable income in the income year in which FRE 2 happens.