Edited version of private advice

Authorisation Number: 1051994286837

Date of advice: 20 July 2022

Ruling

Subject: CGT - granting perpetual licence

Question 1

Do the receipts under the licence agreement (LA) constitute assessable income in accordance with section 6-5 Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

No.

Question 2

Are the receipts under the LA capital in nature and accordingly assessable under the capital gains tax (CGT) provisions in Parts 3-1 of the ITAA 1997?

Answer

Yes.

Question 3

If the receipts are on capital account, which CGT Event are they related to?

Answer

CGT Event D1.

Question 4

If the receipts are on capital account, what would be the date that the related CGT asset was acquired?

Answer

When you started creating the product subject to the licence.

Question 5

If the receipts are on capital account, do you pass the active asset test in relation to its granting of the licence under the licencing agreement?

Answer

Yes, since the product the licence relates to is considered to have passed the active asset test, the licence itself is considered to pass the active asset test due to the operation of section 152-12 of the ITAA 1997.

This ruling applies for the following period

Income year ended 30 June 20XX

The scheme commences on:

1 July 20WW

Relevant facts and circumstances

You are a private company that has developed a product.

You have granted an exclusive license to distribute the product to a related company, in return for which you receive a monthly royalty. The product has been distributed and royalties paid for a number of years and continue to the present time.

Recently, you entered into a license agreement with an unrelated third party, to grant, for a one-off license fee, a world-wide, irrevocable, perpetual, royalty-free, non-exclusive, transferable and sub-licensable licence to install, use, modify, develop and commercialise the product.

The agreement has, in essence, enabled the third party to take a copy of the product as it stood at the time, and develop and market it for their purposes.

You continue to own the product, have since done further development on it, and continue to license it to your related party in exchange for an ongoing monthly royalty.

You are a CGT small business entity as you carry on a business and your turnover is under $X million.

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 10-5

Income Tax Assessment Act 1997 Part 3-1

Income Tax Assessment Act 1997 Section 104-35

Income Tax Assessment Act 1997 Section 109-10

Income Tax Assessment Act 1997 Section152-10

Income Tax Assessment Act 1997 Section 152-12

Reasons for decision

Summary

The one-off payment received in relation to granting the perpetual product licence is capital in nature and subject to the capital gains tax provisions in Part 3.1. CGT event D1 occurred when you entered the licence agreement as you granted a contractual right over the product but retain ownership of it.

The product would be considered acquired when you commenced developing it.

You will have passed the active asset test as the right giving rise to CGT event D1 (the software licence) is inherently connected with the software itself. This allows you to satisfy the active asset test under section 152-12 as it is considered that the software would satisfy the active asset test.

Detailed reasoning

Revenue or capital

An approach to distinguishing between revenue and capital receipts is to examine the character of the receipt from the point of view of the recipient. This approach has been utilised in a number of cases dealing with the revenue/capital distinction.

In McLaurin v FC of T (1961) 104 CLR 381 the High Court held (at p 391):

"...in point of law it would plainly be unsound to allow a determination of the character of a receipt in the hands of a recipient to be affected by a consideration of the uncommunicated reasoning which led the payer to agree to pay it."

In Scott v FC of T (1966) 117 CLR 514 Windeyer L held (at p526):

"Whether or not a particular receipt is income depends upon its quality in the hands of the recipient."

In GP International Pipecoaters Pty Ltd v Federal Commissioner of Taxation (1990) 170 CLR 124 the High Court of Australia held that whether a receipt is income or capital depends on its objective character in the hands of the recipient. It was further stated at page 138 that:

To determine whether a receipt is of an income or of a capital nature, various factors may be relevant. Sometimes, the character of receipts will be revealed most clearly by their periodicity, regularity or recurrence; sometimes, by the character of a right or thing disposed of in exchange for the receipt; sometimes, by the scope of the transaction, venture or business in or by reason of which money is received and by the recipient's purpose in engaging in the transaction, venture or business.

Receipts of a capital nature do not constitute income according to ordinary concepts, whether or not incurred in carrying on a business.

The nature of a payment for a licence has been the subject of some judicial consideration in the United Kingdom and Australia. Lord Denning provided a good description of how amounts received for the granting of a licence are generally viewed in Murray (Inspector of Taxes) v Imperial Chemical Industries Ltd [1967] 2 ALL ER 980 (Imperial). Lord Denning in Imperial at 982-983 stated in the context of an assignment of patent rights:

I see no difference in this regard between an assignment of patent rights and the grant of an exclusive licence for the period of the patent. It is the disposal of a capital asset. But this does not determine the quality of the money received. A man may dispose of a capital asset outright for a lump sum, which is then a capital receipt. Or he may dispose of it in return for an annuity, in which case the annual payments are revenue receipts. ..... If and in so far, however, as he disposes of them outright for a lump sum which has no reference to anticipated user, it will normally be capital (such as the payment of £pound;25,000 in the British Salmson case).

The observations of Lord Denning in Murray were referred to in Kwikspan Purlin System Pty Ltd v Commissioner of Taxation (Cth) (1984) 71 FLR 154 (Kwikspan) by Campbell J at 159. In Kwikspan it was determined that certain lump sum receipts received for the grant of exclusive licences to use a patented invention in different parts of Australia were not part of a profit-making undertaking or scheme and were therefore capital in nature. Furthermore as the company in question was not in the business of dealing in patents, the receipts were not on income account.

You are in the business of developing the product, not in the business of selling the product. You have received a one-off payment that grants Sage perpetual and irrevocable use of your product while you retain ownership of the product and can continue to use it and exploit it as you see fit.

On the basis of the above it is determined that the licence fee for the licence paid by Sage to you under the licence agreement is capital in nature and therefore not assessable as ordinary income under section 6-5.

However, section 6-10 includes some amounts in your assessable income that are not ordinary income. These amounts are called statutory income. Section 10-5 lists statutory income provisions and includes capital gains, referring to section 102-5 in Part 3-1 of the ITAA 1997. Section 102-5 provides that your assessable income includes your net capital gain for an income year and is applicable to the capital gain you have made on entering the product licence agreement.

CGT Event

CGT event D1 (section 104-35) happens 'if you create a contractual right or other legal or equitable right in another entity'. The time of the CGT event D1 will be when the right is created.

You will make a capital gain if the capital proceeds from creating the right are more than the incidental costs you incurred that relate to the event. You will make a capital loss if those capital proceeds are less than those costs.

Taxation Determination TD 2018/15 Income tax: capital gains: does CGT event CGT event D1 happen if a taxpayer grants an easement, profit à prendre or licence over an asset? provides the Commissioner's view on the application of section 104-35 of the ITAA 1997 in instances where a right is granted.

As confirmed in TD 2018/15, CGT event D1 occurs if you grant a licence to another entity.

The product licence that you granted to the third party provides the third party with the perpetual use of the product. It does not provide the third party with ownership or title of the product. You remain owner of the product and can continue to utilise it.

At the time you granted the product licence to the third party, CGT event D1 will happen. The product licence fee is considered capital proceeds received as a result of CGT event D1 occurring.

Acquisition date

A CGT asset can be acquired as a result of a CGT event or by the creation of a right. A CGT asset is generally acquired at the time of the CGT event or when the other relevant event happens. The time of acquisition of a newly created CGT asset is generally when the asset is created.

The table in section 109-10 lists the acquisition rules where a CGT event is not involved. Item 1 of this table provides that if you create a CGT asset and you own it when the asset is created, then you acquire that asset when the work that resulted in its creation started.

Therefore you are considered to have acquired the product, which is the subject of the licence agreement with the third party, when you started creating or developing that product.

Note: As per TD 2018/15 and section 110-10, with CGT Event D1, no part of the cost base of the product can be taken into account in working out the amount of any capital gain or capital loss that arises from the grant of a licence over that the product.

Active Asset Test

As well as meeting the basic condition of being a CGT small busines entity, the other basic conditions that you usually have to meet are:

•         a CGT event happens in relation to a CGT asset of yours in an income year (paragraph 152-10(1)(a); and

•         the CGT asset satisfies the active asset test (paragraph 152-10(1)(d)).

However, the effect of subsection 152-12(1) is that paragraphs 152-10(1)(a) and (d) do not apply in the case of CGT event D1.

Instead, subsection 152-12(2) requires that the right giving rise to CGT event D1 must be inherently connected with another CGT asset which satisfies the active asset test.

The term 'inherently connected' is not defined in the Income Tax Assessment Act 1997 and therefore takes its ordinary meaning.

The principal purpose of the licence agreement is to provide for the granting of a perpetual licence of your product to the third party. All the rights you have granted by entering into the licence agreement are related to their use of your product. Therefore, we consider that the rights you have created by entering into the licence agreement are inherently connected to that product.

Therefore it needs to be determined whether the product passes the active asset test under section 152-35 in order for you to satisfy the basic conditions needed to access the small business CGT concessions.

For the product to pass the active asset test, first it has to be considered an active asset. Active asset is defined in section 152-40 and includes intangible assets that you own and that are inherently connected with a business that is carried on by you.

You have created the product and you have used it in your business for all of the period you have owned it. Your business is the development and licencing of the product and so the product is inherently connected to your business. It is considered that the product satisfies the active asset test under section 152-35.

Consequently, subsection 152-12(2) is satisfied and therefore the basic conditions for the small business CGT concessions have been met in relation to your CGT event D1.