Tax Treatment of The Sale
and Acquisition of
Intellectual Property
Lorne Saltman
© 2009 Cassels Brock
Federated Press Course
June 3, 2009
General Comments on
Intangible Property
In the modern world of business, the
main force of economic activity and
growth is intangible or intellectual
property
Critical questions arise: how do you
identify intangibles, separate them from
other sources of income, and impose tax
appropriately?
© 2009 Cassels Brock
2
Outline of Presentation
• Tax Treatment of Costs of Acquisition,
Development and Use of IP
• Tax Treatment of Receipts for
Exploitation of IP
• Sale versus Lease Transaction
• Acquiring IP From a Non-Resident
• Transferring IP Offshore
© 2009 Cassels Brock
3
Meaning of “Intellectual
Property” for tax purposes
The terms “intellectual property” and
“intangibles” are often interchangeable
It is often said that an intangible must be
directly observable and commercially
transferable
© 2009 Cassels Brock
4
Meaning of “Intellectual
Property” for tax purposes
Intangibles can be classified into
•
•
© 2009 Cassels Brock
Manufacturing intangibles, e.g. patents,
inventions, trade secrets, formulae, processes,
designs, patterns or know-how; and
Marketing intangibles, e.g. trademarks, brand
names, symbols or pictures having an
important promotional value for the product
concerned, copyright, franchises, licences,
distribution channels, methods, systems,
studies, forecasts, customer lists or technical
data relating to marketing
5
Costs of Acquisition,
Development and Use of IP
The
principles
governing
the
determination of whether an expenditure
for developing, acquiring or using IP is
fully deductible for purposes of the
Income Tax Act (Canada) are essentially
the same as for other types of
expenditures
© 2009 Cassels Brock
6
Costs of Acquisition,
Development and Use of IP
• A taxpayer’s income from a business or property is the
taxpayer’s profit from that business or property for the
year
• Generally, income from a business is determined in
accordance with well-accepted principles of business,
accounting or commercial trading
• Accordingly, ordinary business expenses, the
deduction of which is not otherwise prohibited by a
specific provision of the ITA, may be deducted in
computing income from a business
© 2009 Cassels Brock
7
Costs of Acquisition,
Development and Use of IP
• No outlay or expense is deductible
unless it is made or incurred for the
purpose of gaining income from a
business or property
• No outlay or payment on account of
capital
is
deductible
except
as
specifically permitted by the ITA
© 2009 Cassels Brock
8
Costs of Acquisition,
Development and Use of IP
• An amount payable (whether by lump
sum or by instalments) for the acquisition
at one time of all, or substantially all, of
the rights associated with IP will be a
capital expenditure, unless the IP at the
time of acquisition has a short-term
anticipated life
© 2009 Cassels Brock
9
Costs of Acquisition,
Development and Use of IP
• Conversely, royalties paid for the use of
IP owned by another typically are
deductible as an ordinary business
expense
© 2009 Cassels Brock
10
Costs of Acquisition,
Development and Use of IP
• Inventory of a taxpayer can include IP
• Accordingly, where a taxpayer’s business
includes the development or acquisition
of IP on income account, the costs
associated with such IP are deductible at
the time not of acquisition but of
disposition
© 2009 Cassels Brock
11
Costs of Acquisition,
Development and Use of IP
• In computing a taxpayer’s income on an
accrual basis for a taxation year from a
business or property, no deduction may
be made for an outlay or expense to the
extent that it can reasonably be regarded
as having been made or incurred as a
royalty in respect of a period after the
end of the year
© 2009 Cassels Brock
12
Costs of Acquisition,
Development and Use of IP
• The costs of developing, acquiring or
using IP may be on capital account and
may be included within one of the
depreciable classes in the Income Tax
Regulations
• Capital cost allowance may be claimed
by the taxpayer based on the rate of the
applicable class on a declining-balance
basis
© 2009 Cassels Brock
13
Costs of Acquisition,
Development and Use of IP
• A patent, franchise, concession or licence for a
limited period, except for a licence to use
computer software, may be included in Class
14 of the ITR
• The amount of CCA is determined by
apportioning the capital cost of each asset in
the class over its life remaining at the time the
cost was incurred (may be straight-line or
another method that is reasonable)
© 2009 Cassels Brock
14
Cost of Patents
• Property that is a patent or a right to use
patented information for a limited period
or unlimited period that is acquired on
capital account is included in Class 44
• The undepreciated capital cost of Class
44 is eligible for CCA on a 25%
declining-balance basis
© 2009 Cassels Brock
15
Cost of Patents
• One would elect Class 14 over Class 44
if the remaining life of the patent under
the licence is short, resulting in a higher
CCA claim
© 2009 Cassels Brock
16
Cost of Patents
• Where the capital cost of a patent is
determined by reference to the use of the
property, the taxpayer may apportion the
capital cost of the property between the part
dependent on use and the part not dependent
on use
• The capital cost that is dependent on use may
be deducted in full as CCA. The part that is
not dependent on use may be deducted as
CCA in the normal manner
© 2009 Cassels Brock
17
Cost of Patents
Assume patent
price is $1,000 plus
royalty of 10% of
revenues, resulting
in additional $1,000
annual payments
Customary CCA
deduction
Optional CCA
deduction
© 2009 Cassels Brock
Year One
(1/2 rate)
Year Two
2,000 x 12.5% =
250
1,750 + 1,000=
2,750 x 25%=
687.50
1,000 x 12.5% =
125, plus 1,000 =
1,125
875 x 25%= 218.75,
plus 1,000 =
1,218.75
18
Cost of Patents
• The capital cost of a patent will include not
only legal expenses incurred in applying for the
patent, but also costs incurred to develop the
invention to the point of application
• However, the capital cost of a patent will not
include any costs incurred to develop the
invention which have been included in the
taxpayer’s SRED or which have been properly
deducted as ordinary operating expenses
© 2009 Cassels Brock
19
Cost of Patents
• In the CRA’s view, an expenditure made
to acquire a patent will be an eligible
capital expenditure if the expenditure
does not result in the acquisition of a
depreciable property
© 2009 Cassels Brock
20
Deductibility of Eligible
Capital Expenditures
• A taxpayer may deduct in computing income
from a business an amount up to 7% of its
“cumulative eligible capital” at the end of the
year
• The taxpayer’s CEC generally includes threequarters of all eligible capital expenditures
made or incurred by the taxpayer in respect of
the business, and is reduced by all deductions
of CEC previously made by the taxpayer, and
by three-quarters of the net proceeds from
dispositions of eligible capital property
© 2009 Cassels Brock
21
Costs of Copyright
• Copyright that is acquired during a
creator’s lifetime will not qualify for Class
14, because the remaining life of the
copyright is indeterminate
• However, copyright that is acquired after
the creator’s death or during that
person’s lifetime under a limited-term
licence should qualify for Class 14
© 2009 Cassels Brock
22
Costs of Computer Software
• A licence to use computer software is
specifically excluded from Class 14
• Most computer software other than systems
software will qualify as Class 12 property for
which the CCA rate is 100%, where the
software is capital in nature
• The half-year rule is suspended for qualifying
acquisitions of computer software between January
27, 2009 and February 2011.
© 2009 Cassels Brock
23
Costs of Computer Software
• Computer software is defined to include a right
or licence to use computer software, but is not
considered by the CRA to include a contractual
right or licence of a capital nature to buy and
resell, to sublet or to otherwise market
computer software
• Such a contractual right is considered a Class
14 property if it is for a limited life or eligible
capital expenditure if the life is indeterminate
© 2009 Cassels Brock
24
Costs of Computer Software
• Systems software typically falls within
Class 10 at a 30% CCA rate, although
another class may apply depending on
the connection with property of that other
class
• The rate is increased to 100% for qualifying
acquisitions of computer systems software
between January 27, 2009 and February
2011.
© 2009 Cassels Brock
25
Costs of Trade-Marks
• A trade-mark has an indefinite life and so
cannot qualify for Class 14
• The CRA does not consider that it constitutes a
depreciable property that comes within any
class in Schedule II of the ITR
• Rather, its cost will be either an ordinary
expense if on income account or eligible
capital expenditure if on capital account
© 2009 Cassels Brock
26
Costs of Trade Secrets and KnowHow
• Unregistered trade secrets or know-how
likely will not qualify for Class 14
treatment, because the rights associated
with their use may have an indefinite life,
and
because
know-how
is
not
considered property
• The cost of a trade-secret that is
acquired on capital account usually will
be an eligible capital expenditure
© 2009 Cassels Brock
27
Expenditures on Scientific
Research & Experimental
Development
• The costs of an ongoing nature incurred
by a taxpayer to develop IP may be fully
deductible when incurred, in accordance
with the judicial principles decided under
ss. 9(1)
• However, s.37 establishes a specific
code for the deduction of SRED
© 2009 Cassels Brock
28
Expenditures on Scientific
Research & Experimental
Development
• S. 37 expands the range of deductions
immediately available to a taxpayer by
including qualifying capital expenditures that
otherwise might only be deductible over time
as CCA or cumulative eligible capital amounts
• Also, s. 37 provides for the calculation of an
expenditure pool for SRED that effectively
gives the taxpayer the option of deducting an
SRED expenditure in a subsequent year rather
than in the year of the expenditure
© 2009 Cassels Brock
29
Expenditures on Scientific
Research & Experimental
Development
• S. 37 is supplemented by
• s.127 which provides an investment tax
credit for a somewhat narrower range of
expenditures than under s.37, and
• s. 127.1 which may permit the taxpayer to
receive a refund of all or a portion of ITC’s
earned by it even where it has no current tax
liability against which to deduct the ITC
© 2009 Cassels Brock
30
Payment for Restrictive
Covenants
• The term “restrictive covenant” covers not only
non-competition covenants, but also an
agreement entered into, an undertaking made,
or a waiver of an advantage or right by the
taxpayer (other than an agreement or
undertaking for the disposition of the
taxpayer’s property) that affects, or is intended
to affect, the acquisition or provision of
property or services by the taxpayer or by
another taxpayer that does not deal at arm’s
length with the taxpayer
© 2009 Cassels Brock
31
Payment for Restrictive
Covenants
• Where an amount is paid for a restrictive
covenant in conjunction with acquisition
of a business, the payer of the amount
may make a joint election with the
recipient, and will be allowed to include
the payment in the cost of ECE
© 2009 Cassels Brock
32
Receipts for Exploitation of
IP
Both the way IP is exploited and the form
of consideration received for its
exploitation affect the tax treatment of
the proceeds received
© 2009 Cassels Brock
33
Receipts for Exploitation of
IP
• Revenue realized from exploiting IP that
is the focus of the taxpayer’s business
will generally be taxed on income
account, regardless of whether the
taxpayer sells the IP, assigns rights to
different markets on an exclusive or nonexclusive basis, or licenses the IP for a
royalty
© 2009 Cassels Brock
34
Receipts for Exploitation of
IP
• For a disposition of IP to be considered
on capital account, the taxpayer must in
fact part with some of its property and,
thus, must grant to the recipient some
degree of exclusivity in the IP
© 2009 Cassels Brock
35
Receipts for Exploitation of
IP
Royalties or other amounts on income
account will be included in income under
ss. 9(1) in the year of receipt, if the
taxpayer has an absolute entitlement to
the amount and is subject to no
restriction as to its disposition, use or
enjoyment
© 2009 Cassels Brock
36
Receipts for Exploitation of
IP
An amount may alternatively have to be
included in income under par.12(1)(a) if
received in the course of a business on
account of services to be performed after
the end of the year, or for any other
reason may be regarded as not having
been earned in the year
© 2009 Cassels Brock
37
Receipts for Exploitation of
IP
A reasonable reserve may be deducted under
paragraph 20(1)(m) for amounts included in
income under 12(1)(a), in respect of goods or
services that may reasonably be anticipated
will be delivered or rendered after the end of
the year, or for periods for which rent or other
amounts for the possession or use of chattels
(including IP contractual rights in certain
cases) have been paid in advance
© 2009 Cassels Brock
38
Receipts for Exploitation of
IP
This reserve will be available, for
example, where a licensor of IP is
required during the term of years of the
licence to perform ongoing services,
such as protecting the licensee’s lawful
rights in the specified territory to use the
licensed IP
© 2009 Cassels Brock
39
Receipts for Exploitation of
IP
Where consideration receivable for the
disposition of IP is an amount that varies
depending on the production or use
made of the property, paragraph 12(1)(g)
may deem all proceeds to be income to
the taxpayer, notwithstanding that the
transaction
otherwise
would
be
considered to have occurred on capital
account
© 2009 Cassels Brock
40
Receipts for Exploitation of
IP
The following principles reflect the
jurisprudence
and
the
CRA’s
administrative practice:
• Where all the payments under the
agreement of sale are based on production
or use, those amounts are brought into
income when received by the taxpayer;
© 2009 Cassels Brock
41
Receipts for Exploitation of
IP
• Where the agreement provides for the
payment of a fixed sum, plus an
additional amount should production or
use exceed a stipulated figure, the fixed
sum will be treated as proceeds of
disposition and the additional amounts, if
any, will be brought into income
© 2009 Cassels Brock
42
Receipts for Exploitation of
IP
• Where the agreement provides for payments
based on production or use and also stipulates
a minimum sale price, or minimum annual
payments, the payments based on production
or use are brought into income, irrespective of
whether they are less than or exceed the
minimum amount; however, any other
payments which must be made in order to
achieve the minimum requirements are treated
as proceeds of disposition
© 2009 Cassels Brock
43
Receipts for Exploitation of
IP
• Where the agreement calls for payment
of a fixed sum, but the timing of the
payments of that sum varies depending
on production or use, paragraph 12(1)(g)
does not apply
© 2009 Cassels Brock
44
Receipts for Exploitation of
IP
• Where the sale price is an amount equivalent
to the fair market value of the property at the
time of the sale, but can be decreased if
certain conditions relating to production or use
are not met in the future, the maximum amount
will be considered to be the proceeds of
disposition, provided there is a reasonable
expectation at the time of disposition that the
conditions will be met
© 2009 Cassels Brock
45
Receipts for Exploitation of
Intangibles
• Where on a sale of IP, a portion of the
sale proceeds is allocated (or should
have been allocated) to a restrictive
covenant provided by the taxpayer, that
allocated amount may be deemed to be
income under proposed s.56.4
© 2009 Cassels Brock
46
Receipts for Exploitation of
Patents
• Amounts (including lump sums) received for
the granting of a non-exclusive license to use
patents have been found to be income
receipts.
• A lump sum received for granting an exclusive
license to exploit a patent within a specified
area may be a capital receipt, provided that the
taxpayer’s business does not include buying
and selling patent rights, or otherwise dealing
in patents
© 2009 Cassels Brock
47
Receipts for Exploitation of
Copyright
• A distinction has been drawn between
compensation received by a writer or
artist for his/her services in creating a
work which is clearly taxable as ordinary
income, and the sale by a person of the
copyright to a work, which in some
circumstances can give rise to a capital
receipt
© 2009 Cassels Brock
48
Receipts for Exploitation of
Copyright
• A receipt by a writer or artist may be on capital account
where the payment is received after that person ceases
their career or in connection with the cessation of their
business
• Proceeds received on the sale of copyright out of the
ordinary course of business (for example, the sale price
received by a publisher selling all the assets of its
business as a going concern) normally would be
received on capital account
© 2009 Cassels Brock
49
Receipts for Exploitation of
Copyright
Because computer software developers
normally retain copyright, proceeds
received by them from licensees
generally will be on income account.
© 2009 Cassels Brock
50
Receipts for Exploitation of
Know-How
• The CRA’s view, based on the jurisprudence,
is that proceeds from outright sale of knowhow will be considered proceeds from the
disposition of eligible capital property, whereas
if knowledge is not sold outright but merely
licensed for a limited period of time, or its use
is permitted under the terms of a non-exclusive
licence, the total proceeds for the right to use
the trade secrets will be considered income
from exploiting the IP or from rendering
services
© 2009 Cassels Brock
51
Capital Receipts for
Exploitation of IP
• Proceeds of disposition of IP that is
depreciable property, as reduced by
applicable outlays and expenses, will be
deducted from the undepreciated capital
cost of the appropriate class of
depreciable property to the extent that
such net amount does not exceed the
capital cost of such property
© 2009 Cassels Brock
52
Capital Receipts for
Exploitation of IP
• To the extent that such deductions result in a
negative balance at the end of the year, that
balance of “recaptured depreciable” will be
included in the taxpayer’s income.
• If there is a positive UCC of a class following
the disposition of all the depreciable properties
of that class, that balance usually can be
deducted as a “terminal loss”
© 2009 Cassels Brock
53
Capital Receipts for
Exploitation of IP
• Any excess of proceeds of disposition of
a depreciable property over its capital
cost and applicable outlays or expenses
will be accounted for separately as a
capital gain. No capital loss may be
recognized on the disposition of a
depreciable property
© 2009 Cassels Brock
54
Capital Receipts for
Exploitation of IP
• Eligible capital amounts received are
deducted from the balance of a
taxpayer’s cumulative eligible capital in
respect of a business at three-quarters
rates
• Cumulative eligible capital generally
includes three-quarters of all eligible
capital expenditures made or incurred by
the taxpayer in respect of the business
© 2009 Cassels Brock
55
Capital Receipts for
Exploitation of IP
• Eligible capital amount includes three-quarters
of an amount received by a taxpayer on
account of capital in respect of a business,
other than an amount that
• is included in computing the taxpayer’s income, or
deducted in computing any balance of undeducted
outlays, expenses or other amounts,
• reduces the cost or capital cost of property or the
amount of an outlay or expense, or
• is included in computing any gain or loss of the
taxpayer from a disposition of a capital property
© 2009 Cassels Brock
56
Capital Receipts for
Exploitation of IP
• Where eligible capital amounts received
are credited against the taxpayer’s
cumulative eligible capital resulting in a
negative balance at the end of a year,
that amount will generally be included in
the taxpayer’s income from the related
business
at capital
gains
rates
© 2009 Cassels Brock
57
Sale Versus Lease
Transaction
• Prior to 2001, CRA’s IT-233R stated that
where a lease had a purchase option
with an exercise price at less than fair
market value, the lease would be
considered a sale
• This was intended to curb abuses in
leases where the substance of the
transactions disclosed that the parties
intended to effect a sale
© 2009 Cassels Brock
58
Sale Versus Lease
Transaction
• Supreme Court held in Shell Canada Limited v.
The Queen and other decisions that the
economic realities of a situation cannot be
used to recharacterize a taxpayer's bona fide
legal relationships
• Absent a specific provision of the ITA to the
contrary or a finding that there is a sham, the
taxpayer's legal relationships must be
respected in tax cases.
© 2009 Cassels Brock
59
Sale Versus Lease
Transaction
• The determination of whether a contract is a
lease or sale is based on the legal relationship
created by the terms of the agreement, rather
than on any attempt to ascertain the underlying
economic reality
• Legal substance will be examined, so that if a
lessee automatically acquires title to the
property after payment of a specified amount
of rentals, the legal relationship would be one
of purchaser/vendor rather than lessee/lessor
© 2009 Cassels Brock
60
Sale Versus Lease
Transaction
• Notwithstanding the legal relationship,
GAAR may be used to assess cases in
which there is an avoidance transaction
that results in a misuse or an abuse of
provisions of the ITA
© 2009 Cassels Brock
61
Sale of Shares of a
Corporation Owning IP
• Matters to consider:
• Personal and corporate tax integration when capital
gains or recapture realized by Canadian-controlled
private corporation and distributed to shareholder
• Lifetime Capital Gains Exemption now $750,000.
But “qualified small business corporation shares”
depend on value derived from IP used in “active
business”
• Earn-out treatment for capital gains on disposition
of shares versus income treatment under par.
12(1)(g) if IP transferred directly and payment
based on production or use
© 2009 Cassels Brock
62
Acquiring IP From a NonResident
• Most payments made to non-residents for royalties on
account of the right to use IP (other than copyright) in
Canada will be subject to 25% withholding tax
• Canada’s tax treaties generally reduce the rate to 10%
• In some treaties (e.g. with U.S.A.) an exemption
applies for payments for the use of, or the right to use,
any patent or any information concerning industrial,
commercial or scientific experience (but not including
any such information provided in connection with a
rental or franchise agreement)
© 2009 Cassels Brock
63
Acquiring IP From a NonResident
• Withholding tax will not apply to proceeds of
sale by non-resident
• Accordingly, a sale rather than license may
only subject the non-resident to tax on
business income
• Consider whether non-resident may be
carrying on business in Canada, and
• If a tax treaty is applicable, whether the profits
are attributable to a permanent establishment
of the non-resident in Canada
© 2009 Cassels Brock
64
IP Cost-Sharing Agreement
• Payment by a resident to a non-resident
pursuant to a Cost-Sharing Agreement may
avoid royalty withholding tax and transfer
pricing issues
• Costs must be shared on a reasonable basis,
and
• The Canadian resident must obtain some
reasonable right to use the IP that has been
developed
© 2009 Cassels Brock
65
Transferring IP Offshore
• Propose to shift business and profits associated with IP to a
low-tax jurisdiction
• Ideal to move IP offshore before its value increases
significantly
• Transfer must occur at fair market value – should be welldocumented and determined by an independent appraiser
• Consider alternative ways to transfer IP to a corporation
resident in a low-tax jurisdiction along with associated risks
• Residency and location of the associated business of the
transferee should be well-established
• Increased CRA enforcement activities
© 2009 Cassels Brock
66
Presenter
Lorne H. Saltman
Phone: 416 869 5386
Fax: 416 350 6912
Email: lsaltman@casselsbrock.com
© 2009 Cassels Brock
67
www.casselsbrock.com
2100 Scotia Plaza, 40 King Street West, Toronto, Canada M5H 3C2 Phone 416 869 5300
© 2008 Cassels Brock & Blackwell LLP. Cassels Brock and the CB logo are registered trade-marks of Cassels Brock & Blackwell LLP.
™ Trade-mark of Cassels Brock & Blackwell LLP. All rights reserved.
© 2009 Cassels Brock