Long Overdue Reform - II

PAUL EAGLAND ACA, ATII and ALLAN CINNAMON FCA continue their examination of the new intellectual property régime.

The first part of this article was published in last week's issue of Taxation at pages 95 to 98.

ANOTHER MAJOR DEPARTURE from the previous intellectual property régime is the facility to rollover gains on the disposal of intellectual property against reinvestment into any class of new intellectual property.

Previously, the only category for which rollover relief under section 152, Taxation of Chargeable Gains Act 1992 was available was goodwill (section 155, Class 4). Gains on the disposal of any other class of intellectual property could not be rolled over; similarly, reinvestment in any class of intellectual property other than goodwill negated the possibility of rollover relief.

(It should be noted that statutory references, unless otherwise indicated, are to the draft legislation published on 27 November 2001 (available together with detailed explanatory notes from www.inlandrevenue.gov.uk).)

Under the new régime, gains from disposals of any class of intellectual property (including goodwill) are eligible for rollover against reinvestment in any class of intellectual property (including goodwill). What is more, investment intellectual property qualifies on an equal footing with intellectual property used for a trade. The conditions for the new rollover form part of a self-contained code (Part G of the draft legislation), which excludes sections 152 to 160, Taxation of Chargeable Gains Act 1992. From 1 April 2002, goodwill is removed from the general rollover code, as are milk quotas, potato quotas, ewe and suckler-cow premium quotas and fish quotas (paragraph N13(5)), subject to transitional provisions.

Conditions for rollover relief

The Part G code mirrors the general rollover rules, and will therefore not be discussed in detail here. The main conditions for Part G rollover are:

• the old and the new intellectual property must be intangible fixed assets (paragraph G1(1));
• the new régime must apply to the old intellectual property at the date of the disposal (referred to as a realisation in Part G) (paragraph G2(1)(a));
• the old intellectual property must have been used for a trading or commercial purpose (including investment) for the whole or a substantial part of the ownership period (paragraph G2(2));
• the new intellectual property must be capitalised for accounting purposes and must be intellectual property to which the new régime applies (paragraph G3(1)(b), (c));
• the new intellectual property must be acquired within a period beginning 12 months before the disposal and ending three years after the disposal, although the Revenue has discretion to extend the period in both directions (paragraph G3(1)(a));
• the realisation proceeds of the old intellectual property must be greater than its tax cost (paragraph G2(1)(b));
• where there is a part disposal, it must not be to a related party (paragraph L2);
• the old and the new intellectual property may be the same asset, if the company reacquires the old property after having disposed of it (paragraph G7);
• the disposal must be an actual disposal, not a deemed disposal, except where the degrouping charge is rolled over (paragraph G8).

Where these conditions are satisfied, and a claim for Part G rollover is made, the realisation proceeds of the old intellectual property are reduced by the relievable amount, as is the tax cost of the new intellectual property (paragraph G5(1)).

Relievable amount

If the amount reinvested is equal to or greater than the proceeds, the relievable amount is the gain for tax purposes, i.e. the proceeds reduced by the tax cost (paragraph G5(2)).

If the amount reinvested is less than the proceeds, the relievable amount is the amount by which the reinvestment exceeds the tax cost (paragraph G5(3)).

Claims

Claims must be made within four years of the end of the accounting period in which the old intellectual property is realised (paragraph G6(5)).

Companies may make provisional claims in the return for the period in which the old intellectual property is realised. Such claims need only specify that the company has realised an item of intellectual property, that it intends to meet the conditions for relief and the amount it intends to claim (paragraph G6(2)).

Group basis for rollover

A claim can be made for Part G rollover within a group of companies, where one group member realises the old intellectual property and another group member makes the investment into new intellectual property (paragraph I3). However, Part G rollover relief is not available if the new intellectual property is acquired in a tax-neutral transfer from the other group member (paragraph I3(4)).

Special rules for groups

Meaning of 'group'

The new régime contains its own definition of a 'group' (Part H). This closely models the general capital gains rules. Thus:

• a group consists of a principal company and its 75 per cent subsidiaries and their 75 per cent subsidiaries, etc.;
• each subsidiary must be an effective 51 per cent subsidiary of the principal company;
• the principal company cannot itself be the 75 per cent subsidiary of another company;
• world-wide group ownership applies, so that a group can consist of commonly owned 75 per cent subsidiaries of a foreign parent or of a United Kingdom 75 per cent subsidiary and the United Kingdom branch of the foreign parent;
• a company cannot be a member of more than one group.

Intra-group transfers

Intellectual property may be transferred on a tax neutral basis between group members (paragraph I1). This means that the transferor company has not made a realisation of the intellectual property and the transferee company has not made an acquisition. The transferee company stands in the shoes of the transferor and inherits the tax written down value and the tax history of the intellectual property (paragraph O6).

Tax-neutral transfers may not be made to or from a dual-resident company (paragraph I1(2)(b)).

In most cases, the tax neutral treatment for tax purposes will be reflected in the accounting treatment. However, there may be divergences for accounting purposes, as where, for example, there are minority interests and the intellectual property is actually transferred at market value. Where this is the case, the accounting treatment is followed for accounting purposes.

This has the effect that where the market value exceeds the tax written down value, the transferor company is treated as having made a revaluation and recognised a gain; conversely, if the market value is less than the tax written down value, the transferor is treated as having made an impairment write-down and recognised a loss (paragraph I2).

There are a number of special situations where the intellectual property treatment will follow the existing capital gains treatment with disposals treated on a tax neutral basis. These are described briefly below.

Incorporation of a foreign branch

Gains on intellectual property are rolled over into the cost of shares and/or loan stock where it forms part of the assets of a United Kingdom company's foreign branch which is transferred to a foreign company in exchange for shares and/or loan stock, following which, the United Kingdom company owns 25 per cent or more of the issuing company's ordinary share capital (section 140, Taxation of Chargeable Gains Act 1992; paragraph K3).

However, in contrast to section 140, there is a bona fide commercial requirement and a clearance procedure (paragraph K3(8), (9)).

Transfer of a United Kingdom trade within the European Community

Where intellectual property is transferred as part of the incorporation of an European Community company's United Kingdom branch into a United Kingdom or other European Community company in exchange for securities including shares (section 140A, Taxation of Chargeable Gains Act 1992), the transfer is tax neutral (paragraph K2). Again, there is a bona fide commercial requirement and a clearance procedure (paragraph K2(4), (5)).

Transfer of a non-United Kingdom trade within the European Community

When a United Kingdom company's branch in another European Community member state is transferred to a company resident in another European Community member state (other than the United Kingdom), the European Community Mergers Directive (90/434/EEC) requires the transfer to be free of tax in the member states concerned if the transfer is wholly or partly in exchange for securities. Where the United Kingdom company's aggregate chargeable gains arising from the transfer exceed the aggregate allowable losses from the transfer, the United Kingdom company may claim as a foreign tax credit against the resulting United Kingdom tax payable the foreign tax that it would have paid but for the Mergers Directive (section 815A, Taxes Act 1988, section 140C, Taxation of Chargeable Gains Act 1992).

Paragraph K4 provides a parallel relief for any new régime intellectual property forming part of the branch's assets. Again, there is a bona fide commercial requirement and a clearance procedure (paragraph K4(7), (8)).

Tax free reconstructions

Where intellectual property is transferred as part of a tax free scheme of reconstruction or amalgamation under which the transferor company receives no part of the consideration for the transfer (except an assumption of some or all of its liabilities), such as mentioned in section 139, Taxation of Chargeable Gains Act 1992, the transfer is tax neutral, provided that it is undertaken for bona fide commercial reasons. A clearance procedure is available (paragraph K1).

Rollover or transfer of degrouping charge

Where intellectual property has been transferred between group members on a tax neutral basis, and the transferee company leaves the group within six years, there is a degrouping charge, similar to the general capital gains degrouping charge imposed by section 185, Taxation of Chargeable Gains Act 1992 (paragraph I5). The charge applies equally where the transferee company was not a member of the transferor's group at the time of the transfer (in which case, the transfer would not have been tax neutral) but became one in the intervening period.

The transferee is treated as having disposed of and reacquired the intellectual property immediately after the transfer for its market value at that time. This will also trigger a recomputation of tax amortisation, as well as recognition of the appropriate debit or credit for the deemed realisation. All the consequent adjustments are aggregated and the net resulting debit or credit is recognised in the accounting period in which the transferee leaves the group

Part G rollover relief may be claimed in respect of the deemed realisation if there is reinvestment in new intellectual property within the rollover period (paragraph I11). There is also the possibility of transferring the degrouping charge to another group member (paragraph I12).

Rollover on a share acquisition

In order to achieve neutrality between acquisitions of assets and of shares, a company that has derived gains on the realisation of intellectual property may claim Part G rollover against new régime intellectual property owned by a company in which it has acquired a controlling interest (such that the target company becomes a member of the acquiring company's group, not having been a member previously) (paragraph I4(1), (2)).

In such circumstances, the amount reinvested is deemed to be smaller of (a) the tax written down value of the intellectual property owned by the target company and (b) the acquisition cost (paragraph I4(3)). The tax written down value is then reduced by the relievable amount (paragraph I4(4)).

Controlled foreign company rules

Related party transfers

Except in the case of a transfer between members of the same group or other tax neutral transfers under the new régime, transfers of intellectual property between related parties are deemed to take place at market value (paragraph L1(1)). This rule applies, for example, to:

• incorporations under section 162, Taxation of Chargeable Gains Act 1992;
• acquisitions and disposals involving non-resident group members and affiliates;
• acquisitions and disposals involving related non-domiciliaries and offshore trusts.

The definition of a related party follows that in transfer pricing and controlled foreign company legislation (paragraphs L5-L10). However, the transfer pricing rules of Schedule 28AA to the Taxes Act 1988 have precedence over this market-value rule (paragraph L1(2)). For example, the market value cost of intellectual property acquired from a related party will be entirely disallowed if the transaction is of a type that a third party would not have entered into (paragraph 1(3) of Schedule 28AA).

Acquisitions after 31 March 2002 of intellectual property from a related party will not qualify as new régime intellectual property if it is old régime intellectual property in the related party's hands (paragraph N2(1)(b)). This rule prevents the conversion of old régime to new régime intellectual property by a mere transfer between group members or other related parties.

United Kingdom branches

Intellectual property transferred to a United Kingdom branch from the foreign head office or held by a foreign company on its becoming United Kingdom resident is treated as acquired at its book value (paragraph M7(1)).

When intellectual property ceases to be held for the purposes of a United Kingdom branch's trade, for example, when the branch closes down, it is treated as if it had been realised at its market value (paragraph M5(1)(b)).

Royalty income

Royalty income derived from intellectual property will characterise a controlled foreign company as carrying on an investment business within paragraph 9(1) of Schedule 25 to the Taxes Act 1988. Under paragraph 6(2) of Schedule 25, such a controlled foreign company is disqualified from satisfying the exempt activities test, if the royalty income constitutes its main business and it cannot meet the excluded countries test.

Even where the intellectual property is applied to produce trading, rather than royalty/investment, income, a sale by the controlled foreign company of new régime intellectual property at a substantial profit could disqualify it from the exempt activities test for the period in which the sale takes place. This is because the gain on the new régime intellectual property will constitute taxable income (and thus come within the controlled foreign company rules), whereas gains on old régime intellectual property would be treated as capital gains, which are outside the controlled foreign company rules. However, there is the possibility of claiming Part G rollover relief by giving notice under paragraph 4(2) of Schedule 24 to the Taxes Act 1988 (paragraph M13(3)).

The draft legislation currently contains no provisions for a tax neutral transfer between 75 per cent owned controlled foreign companies.

Anti-avoidance rule

Tax avoidance arrangements are to be disregarded in determining whether a debit for amortisation or impairment under paragraph B3 or a credit on realisation under Part D arises under the new régime (paragraph M8(1)).

An arrangement is a tax-avoidance arrangement, under paragraph M8(2), if its main object or one of its main objects is to enable a company to:

• obtain a debit under paragraph B3 to which it would not otherwise have been entitled or a greater debit than it would have otherwise have been entitled to; or
• avoid bringing a credit into account under Part D or reduce the amount of any such credit.

Transitional rules

General rule

The new régime comes into effect on 1 April 2002. It applies to intellectual property acquired from third parties (other than related parties) after 31 March 2002 and to internally generated intellectual property on which expenditure is commenced after 31 March 2002 (paragraphs N1, N2). It follows that intellectual property acquired or internally commenced before 1 April 2002 will continue to be taxed under the old régime. As regards old-régime intellectual property, therefore:

• capital allowances at 25 per cent on a reducing balance basis will continue to be limited to patents, industrial know-how and computer software and will not be available for expenditure on other intellectual property;
• expenditure on internally generated intellectual property may be disallowed as capital;
• profits on sale of intellectual property will be taxed as capital gains, with indexation relief; and
• capital gains rollover relief will be limited to disposals of goodwill only.

Exceptions

There are two main exceptions to this rule. Firstly, royalties receivable and payable after 31 March 2002 come within the new régime regardless of whether they relate to old or new régime intellectual property (paragraph N3(1)). New régime royalties previously brought into account are ignored; to the extent that they would have been brought into account before 1 April 2002 if the new régime had been in existence, they are brought into account immediately on 1 April (paragraph N3(2), (3)).

The second exception relates to rollover relief under the new régime. Where old régime intellectual property is realised after 31 March 2002, Part G rollover relief may be claimed under the new régime against reinvestment after 31 March 2002 into new régime assets (paragraph N12).

There are special rules concerning old régime goodwill disposed of after 31 March 2002. Capital gains rollover relief may still be claimed against reinvestment into a qualifying class of asset under section 155, Taxation of Chargeable Gains Act 1992, but only where the reinvestment took place before 1 April 2002. From 1 April 2002, those qualifying classes are reduced to Classes 1 to 3 and Class 8, i.e. land and buildings, fixed plant, ships, aircraft and hovercraft, satellites, spacecraft, etc., and certain assets of a member of Lloyd's). Generally speaking, therefore, this facility will cease to be available after 31 March 2003.

Subject to the above condition, relief may be claimed entirely under the new régime, entirely under the capital gains rules, or partly under one code and partly under the other (paragraph N13(2)).

Special provisions

Internally generated intellectual property, including goodwill, involves a programme of continuing expenditure. To the extent that expenditure is incurred on an item of intellectual property both before 1 April 2002 and subsequently, the general rule is that expenditure incurred from 1 April 2002 is treated as if it were expenditure on a separate asset, and falls within the new régime to that extent (paragraph N4(3)).

However, in the case of internally generated intellectual property, expenditure after 31 March 2002 does not create a new asset, and does not fall within the new régime, if the intellectual property was created before 1 April 2002 (paragraph N2(1)(a)).

Internally generated goodwill is treated as created before 1 April 2002 if the business in question had been begun by the company or by a related party before that date (paragraph N5).

Other internally generated intellectual property is treated as created before 1 April 2002 if it was held by the company or by a related party before 1 April 2002 (paragraph N6(3)).

The timing of commencement of a business or of an intellectual property project could thus substantially influence the relevant deductible expenditure. Whereas under the new régime, expenditure on internally generated intellectual property is normally deductible in accordance with the accounts, it could be disallowed as capital expenditure attracting no capital allowances.

These transitional rules do not apply to internally generated intellectual property that currently qualifies for capital allowances, principally capitalised computer software under section 71, Capital Allowances Act 2001. Expenditure on old régime assets of this type does qualify under the new régime but an election can be made for capital allowances instead of accounting amortisation (paragraph J11).

Paul Eagland is head of tax at BDO Stoy Hayward, London. Allan Cinnamon is former head of international tax at BDO Stoy Hayward and is now an international tax consultant with the firm.

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