Long Overdue Reform - I

In the first of a two part article, PAUL EAGLAND ACA ATII and ALLAN CINNAMON FCA examine the new intellectual property régime.

THE HUGE STRIDES in technological progress over the last decade have revolutionised the business environment. As a result, intellectual property has become a major asset to many businesses, whether or not they are directly involved in the new technology. In many cases, this intellectual property is not reflected in the balance sheet in accordance with generally accepted accounting policies.

Due to its malleable nature, intellectual property can be exploited by business in many different ways, both domestically and internationally, for instance, the grant of a licence for a royalty or lump sum; the grant of rights for a specific territory or a specific term; the grant of rights of a specific nature, such as film or television rights, and so on. However, the United Kingdom's tax treatment of intellectual property has failed to keep pace with modern developments. Indeed, until now, much of it has still been rooted in 19th or early 20th century concepts of what constitutes trading profits. It has been essentially an amalgam of over 150 years of occasional legislation and judicial decisions, without any logical basis. The result has been a confused picture of differing rules and wide divergence from accounting treatment. Much expenditure of a capital nature on intellectual property has been denied any relief at all.

Unfortunately, given that the new régime took effect from 1 April, the implementing legislation is scheduled to appear in the Finance Bill published on 24 April but it will not take its final form until the end of July.

What is even more unsatisfactory is the fact that when the Inland Revenue confirmed on 26 March as planned, the opportunity was not taken to issue revised draft legislation, as was the case with the substantial shareholdings exemption. Instead, there was an announcement that the legislation would be published in revised form in the Finance Bill, together with further notes explaining the changes.

The analysis and references that follow are therefore necessarily based on the draft legislation published on 27 November 2001 (available together with detailed explanatory notes from www.inlandrevenue.gov.uk), but the detailed rules will be subject to change in a way that we do not yet know. It was announced on 26 March that the Finance Bill will contain revisions to the current draft.

In what follows, 'new régime' means the code contained in the draft legislation and 'old régime' means the code in existence before 1 April 2002.

The new régime in brief

• The new régime applies for corporation tax purposes only.
• Expenditure on intellectual property recognised in the accounts will normally give rise to a tax deductible expense.
• Amortisation of intellectual property, based on the accounts charge, will normally also be tax deductible.
• Receipts (including sale proceeds) in respect of intellectual property will normally be treated as taxable income.
• But gains on the disposal of intellectual property can be rolled over into reinvestment in new intellectual property.
• Transfers of intellectual property within a group will normally be on a tax-neutral basis, but generally transactions with related parties will be deemed to take place at market value.

What is 'intellectual property'?

Definitions

Intellectual property is not a term that has hitherto been defined in tax law. The draft legislation refers throughout to 'intangible fixed assets'. They have a two part definition. 'Intangible asset' has the same meaning as for accounting purposes (paragraph A2(1)). This requires reference to paragraph 2 of Financial Reporting Standard 10 'Goodwill and intangible assets', which yields the following: 'non-financial fixed assets that do not have physical substance but are identifiable and are controlled by the entity through custody or legal rights'.

However, references to an intangible asset are to 'include, in particular, any intellectual property' (paragraph A2(2)).

'Intellectual property' is then defined as:

• any patent, trade mark, registered design, copyright or design right;
• plant breeders' rights or rights under section 7, Plant Varieties Act 1997;
• rights under foreign law corresponding to the above;
• information or techniques not included above but having industrial, commercial or other economic value;
• any licences or other rights relating to any of the above.

A 'fixed asset' is 'an asset that is held, or intended to be held, by the company for use on a continuing basis in the course of the company's activities' (paragraph A3(1)), and includes internally generated fixed assets and options to acquire or dispose of a fixed asset. It does not need to have been capitalised in the company's accounts (paragraph A3(3)).

Goodwill, on the other hand, is not an intangible fixed asset, within these definitions, but the new régime is to apply to it as it does to intangible fixed assets (paragraph A4).

In this article, we shall use 'intellectual property' as a convenient shorthand for all the assets to which the new régime applies. In this context, intellectual property encompasses a wide range of intangibles, including patents; trademarks; copyrights; registered designs and design rights; database rights; computer software; licences (e.g. mobile phone licences, indefeasible rights of use, airline routes); brands; domain names; know-how; trade secrets; customer lists; franchise rights; goodwill; information or techniques having economic value; certain rights in respect of plant varieties.

Most, but not all, of these are listed in paragraph 15 of the Revenue explanatory notes. Goodwill, although not classed by the draft legislation as an intangible fixed asset, is specifically included in the new régime (paragraph A4(1)).

Excluded intellectual property

The following types of intellectual property are specifically excluded from the new régime (paragraphs J2-J6):

• oil and gas licences;
• financial assets;
• rights over tangible assets;
• rights in a company or under a trust;
• a partner's interest in a partnership;
• assets held for non-commercial purposes.

Certain assets are entirely excluded except in relation to royalties (paragraphs J7-J9):

• assets of a life-assurance or mutual business;
• expenditure on films and sound recordings;
• expenditure on computer software treated as part of the cost of the related hardware.

The partial exclusion of films and sound recordings is in order that the current favourable tax treatment (under section 40A(5), Finance (No 2) Act 1992) can continue.

Expenditure on research and development is also excluded, to preserve research and development tax credits for small and medium sized enterprises (and the new research and development credits for large enterprises), but gains on realisation do fall within the new régime (paragraph J10).

Capital expenditure on computer software is also partially excluded to allow companies to elect for capital allowance treatment under section 71, Capital Allowances Act 2001, as previously (paragraph J11). As with research and development, gains on realisation also come within the new régime.

Unacceptable accounts

If the treatment adopted in the accounts does not properly reflect accepted accounting practice, it will be replaced for tax purposes by a treatment that accords with that practice (paragraph A6). This exception would typically apply to United Kingdom branches of companies incorporated outside the United Kingdom, since they are not required to comply with United Kingdom accounting standards.

Tax debits under the new régime

The new régime provides that a 'tax debit' (normally an item of tax deductible expenditure) in respect of intellectual property can arise in five ways (paragraphs B1 and D1):

• as expenditure written off as it is incurred;
• as amortisation of capitalised intellectual property;
• as a write-down following an impairment review;
• as a reversal of a tax credit from a previous accounting period;
• as losses on realisation of intellectual property.

Expenditure written off

Where in any period, expenditure on intellectual property is recognised in a company's profit and loss account, a corresponding debit is brought into account for tax purposes (paragraph B2(1)).

Expenditure on intellectual property is any expenditure incurred on the acquisition, creation, maintenance, preservation or enhancement of that property. It includes abortive expenditure and expenditure on establishing and defending title to that property. It also includes royalties paid for the use of the intellectual property. Whether or not the expenditure would have been treated as capital expenditure under the old régime is irrelevant, except that capital expenditure on tangible assets is specifically excluded (paragraph O2).

Under Financial Reporting Standard 10, the type of expenditure that is written off when incurred and not capitalised is generally:

• abortive expenditure;
• royalties paid for the use of third party intellectual property;
• expenditure on internally generated intellectual property.

Financial Reporting Standard 10 permits internally generated intellectual property to be capitalised only where it belongs to a homogeneous population of assets that are equivalent in every respect and for which an active market exists, as evidenced by frequent transactions (paragraphs 2, 14; Appendix III, paragraphs 25-27).

Amortisation

In another radical departure from previous law, the new régime normally accepts as a tax debit the amount of amortisation provided on capitalised intellectual property under accounting principles, including the amortisation of purchased goodwill.

Financial Reporting Standard 10 recommends that in most circumstances intellectual property be amortised on a straight-line basis over its useful economic life. This will rarely exceed 20 years. It follows that the rate of amortisation will rarely be below five per cent a year. By the same token, straight-line amortisation, except in the case of a short-lived asset, will be less rapid than the 25 per cent reducing balance writing down allowance previously available in the case of capital expenditure on purchased patent rights or industrial know-how.

Where intellectual property is expected to have an indefinite useful economic life (most commonly with brands and goodwill), no amortisation should be charged (paragraph 17 of Financial Reporting Standard 10). Since this would preclude any relief under the new régime for expenditure on such assets, companies are permitted to elect for four per cent amortisation for any particular item of intellectual property. They may do this regardless of the actual accounting treatment. However, a four per cent election is irrevocable, and must be made within two years of the end of the accounting period in which the item is created or acquired (paragraphs B4, B5).

Impairment write-down

Paragraph 34 of Financial Reporting Standard 10 requires impairment reviews to be carried out for each item of intellectual property. In the case of intellectual property being amortised over a period of 20 years or less, this need normally be done only once (at the end of the first full financial year since acquisition); subsequent reviews need to be carried out only if events or circumstantial changes suggest the carrying value may not be recoverable. On the other hand, for intellectual property with an amortisation period of over 20 years (or no accounts amortisation), reviews are to be carried out at the end of every accounts period.

If the review concludes that the carrying value needs to be written down, the amount of the write-down (the impairment loss) is taken to the profit and loss account for accounting purposes. An equivalent debit is brought into account for tax purposes (paragraph B3(1)).

Any remaining accounts amortisation should be carried out over the balance of the asset's useful economic life (paragraph 41 of Financial Reporting Standard 10).

Where tax debits differ

Normally, the tax debit will equal the accounting debit, that being the guiding principle behind the new régime. However, there are occasions when the tax debit will diverge from the accounting debit, even under the new rules.

The most frequent cause for such divergence will probably be where rollover relief has been claimed; another divergence will follow any revaluation of the intellectual property.

However, it is important to remember that most general rules disallowing or deferring recognition of certain expenditure are not overridden by the intellectual property rules. Thus, if any part of the accounting cost of expenditure on intellectual property consists of, for example, entertaining costs or remuneration that remains unpaid more than nine months after the end of the accounting period, that amount is not deductible for tax purposes, and the tax cost of the intellectual property will differ from the accounting cost.

When tax and accounting costs differ on expenditure that is capitalised, the tax deductible amortisation of that expenditure will also differ from the accounting amortisation.

Paragraph B3 provides rules for calculating the tax debit in these circumstances. In the accounting period in which the asset is capitalised, the tax deductible amortisation is given by (paragraph B3(4)):

In subsequent periods, the formula is (paragraph B3(6)):           

This ensures that the tax amortisation continues to bear the same proportion to the accounting amortisation throughout (unless and until there is another adjustment).

Tax credits

Financial Reporting Standard 3, 'Reporting financial performance', requires realised gains and losses on disposals of intellectual property and other assets to be taken to the profit and loss account. Accordingly, under the new régime, most income and gains in respect of intellectual property give rise to a credit for tax purposes, i.e. an item of taxable income. These tax credits should not be confused with the ever growing family of other tax credits.

The draft legislation lists five occasions on which a credit in respect of intellectual property can arise (paragraphs C1, D1):

• receipts recognised in the profit and loss account as they accrue;
• revaluations of intellectual property;
• credits in respect of negative goodwill;
• reversal of a tax debit in previous accounting periods;
• gains on realisation of intellectual property.

Receipts recognised as they accrue

Whenever a gain (other than a gain on realisation) representing a receipt in respect of intellectual property is recognised in the profit and loss account, a corresponding credit is taken into account for tax purposes (paragraphs C1(2), C2(1)). These receipts will include royalties from the granting of rights to third parties.

Revaluations

It is only in limited circumstances that Financial Reporting Standard 10 (see paragraphs 43 and 44) allows (upward) revaluations of intellectual property. These are where:

• external events following the recognition of an impairment loss itself driven by an external event 'clearly and demonstrably' reverse the effects of the previous event in a way that could not have been foreseen, in which case the carrying value is adjusted upwards to the extent of the reversal; or
• the intellectual property has a readily ascertainable market value, in which case it can be restated at that value. Again, this will be the case only where it is part of a homogeneous population, etc.

Where the revaluations are reflected in the profit and loss account, as they normally will be, a corresponding credit is brought into account for tax purposes (paragraph C3(1)). No tax credit need be brought into account if the asset is the subject of a four per cent election (paragraph C3(6)).

However, for tax purposes, a revaluation credit cannot exceed the net aggregate amount of tax debits previously brought into account for that asset (paragraph C3(2)).

Where the tax written down value of the intellectual property immediately before its revaluation differs from its accounting book value, the revaluation adjustment for tax purposes is the amount given by the formula (paragraph C3(3)):

Where an asset has been revalued, Financial Reporting Standard 10 requires its future amortisation to be based on its new valuation (paragraph 47). However, tax amortisation effectively ignores the new valuation and continues to be based on the expenditure recognised for tax purposes, and this in turn, subject to any adjustment, is the amount of the expenditure capitalised for accounting purposes (paragraph B(4), (5)). An increase in value is not expenditure.

Negative goodwill

Negative goodwill can arise exceptionally where the intellectual property was acquired together with other assets of a business. Financial Reporting Standard 7 'Fair values in acquisition accounting', requires fair values to be attributed to the constituent assets. If the aggregate amount of these fair values is greater than the total amount paid for the business, the balance is 'negative goodwill'.

Any negative goodwill must normally be recognised as a gain in the profit and loss account. For tax purposes, a credit arises for so much of the gain as can justly and reasonably be attributable to intellectual property (paragraph C4).

This situation should be avoided if possible, since whereas negative goodwill must be immediately recognised, the amortisation of the acquired intellectual property will be spread over time.

Gains on realisation

Subject to the rollover election, when an item of intellectual property is realised (by sale or transfer), the gain or loss is recognised in the profit and loss account and hence for tax purposes also.

The amount taken into account for tax purposes differs, depending on whether:

• the item has or has not been written down for tax purposes; and
• is or is not shown on the balance sheet.

Items that have been written down

The income (loss) recognised for tax purposes is simply the difference between the proceeds (adjusted for tax purposes where necessary) and the tax written down value (paragraph D3). This can be positive or negative. The tax written down value is simply the aggregate of the tax cost of the asset and previous tax credits and debits (paragraph E1). Assets amortised under the four per cent election will have no recognised credits (paragraph E2).

Items not written down

This category includes intellectual property that has not been amortised, for example because of its indefinite useful life and which has then not been the subject of a four per cent election, and intellectual property that has not been brought into use. The income (loss) recognised for tax purposes is the difference between the proceeds and the tax cost (paragraph D4).

Items not on the balance sheet

This category includes internally generated intellectual property with no readily ascertainable market value (and hence not capitalised). The income recognised for tax purposes is the amount of the realisation proceeds (paragraph D5).

Part realisations

Where an item of intellectual property is only partly realised, the income (loss) recognised for tax purposes is computed by adjusting the tax written down value or the tax cost, as appropriate, according to the proportion the remaining book value bears to the book value before the part-realisation (paragraph D6). Following a part-realisation, the tax written down value of the remaining intellectual property is similarly adjusted (paragraph E3).

Paul Eagland is head of tax at BDO Stoy Hayward, London. Allan Cinnamon is an international tax consultant with the firm. The final part of this article will appear in next week's issue of Taxation.

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