Development and commercialisation projects involve important decisions concerning the creation, ownership, protection and licensing of intellectual property (IP). The tax consequences resulting from decisions such as these must be understood and considered at the time the decisions are made, rather than being left to be worked out when the next tax return is due.
Since July 2001 the Uniform Capital Allowances system (UCA) has applied to a range of depreciating assets, including certain types of IP. An understanding of how the UCA applies to IP can lead to more effective tax planning and structuring of development and commercialisation projects.
What IP is covered?
The UCA applies to a limited range of IP assets, as defined by the Income Tax Assessment Act 1997 (Cth), specifically, copyright, designs and patents. Additionally, the UCA contains special rules which apply to in-house software, some of which are discussed below. The UCA does not apply to other forms of IP, such as trade marks, circuit layout rights, plant breeder's rights and trade secrets, so the identification and classification of IP is fundamental to determining the tax consequences of creating, protecting, using and transferring IP rights.
IP development issues
Expenses incurred in creating IP will be deductible if they are incurred in gaining or producing assessable income, or necessarily incurred in carrying on a business for the purpose of gaining or producing such income. Expenses of capital or a capital nature are not deductible under the general deductibility provisions of the Act. However, the UCA allows depreciation deductions for certain types of IP.
Consideration needs to be given to whether expenditure incurred in creating IP will give rise to outright deductions or capital allowances. The answer will largely depend on whether or not the expenditure is of capital or a capital nature. Expenditure which is incurred to establish or enhance a business structure or organisation for the earning of profit will be of a capital nature. Expenditure incurred in restoring or operating the structure or organisation will not. Therefore, the cost of acquiring or defending an IP right will be of a capital nature. Expenditure on renewing IP rights, or contesting the registration of IP by others, will be deductible as incurred.
The deductibility of expenditure will always depend on the particular facts and circumstances. The classification of expenditure should be thoroughly analysed to ensure that capitalised items are not deductible, and that expenses claimed as deductions are not of a capital nature for taxation purposes.
Where IP development costs are of a capital nature, and the IP asset is one to which the UCA applies and is being used for a taxable purpose, then the person holding the asset is entitled to an annual deduction over its effective life. The annual deduction must be calculated using the 'prime cost' method. The effective life for intangible assets is prescribed by the Act. For a licence relating to copyright, the effective life is the shorter of 25 years or the period until the licence ends. Accordingly, when drafting copyright licences, the term of the licence should be carefully considered so that it meets business requirements while bearing in mind that a long term or perpetual licence may unnecessarily extend the period over which the asset can be depreciated.
For IP to which the UCA does not apply, no annual deduction of capital costs is available. Generally, these other forms of IP (such as trade marks) do not have an effective life and would be expected to increase in value over time, rather than depreciate. For these assets, development and acquisition costs form part of the cost base of the asset which would be taken into account when the asset is disposed of for capital gains tax purposes.
Special rules for in-house software
In-house software is generally defined by the Act as computer software, or a right to use computer software, that you acquire, develop or have another entity develop that is mainly for you to use in performing the functions for which the software was developed. There is potentially overlap between this definition and the definition of intellectual property (which includes the rights of an owner or licensee of copyright). This is important because the statutory effective life for in-house software is just two and a half years (regardless of the term of the licence), compared with up to 25 years for copyright. The classification of developed software or a software licence as either intellectual property or in-house software should be carefully considered, as there may be scope for substantially shortening the depreciation period.
IP protection issues
In Australia, copyright protection is automatic, whereas patent and design protection is not. The decision to patent an invention or register a design can have significant tax consequences. For example, the sale of IP to which the UCA applies will have income tax consequences, whereas the sale of other forms of IP will be subject to capital gains tax.
The decision to patent an invention can be used to illustrate this point. The sale of an invention (in the form of a trade secret or know-how) before it is patented will result in the inventor showing a capital gain or loss. A capital gain may be able to be discounted if the asset has been held by an individual for at least 12 months, whereas a capital loss can only be offset by current or future capital gains. However, if the invention is patented and used for a taxable purpose, then its sale will require an adjustment to the inventor's income to be made under the UCA. No discount is available under the UCA if a profit is made, but a loss resulting from the sale of a patent can be deducted from the inventor's other assessable income.
IP transfer issues
When a taxpayer assigns or grants a licence over IP to another person, the taxpayer is deemed to have stopped holding part or all of the asset, and a balancing adjustment is required to be made. A balancing adjustment will result in a tax liability if the holder of an IP asset disposes of it for more than its written-down value. An allowance is made if an IP asset is disposed of for less than its written-down value.
The choice between granting an exclusive licence versus a non-exclusive licence is an important commercial decision for many reasons, one of which is the tax consequences under the UCA. Granting a licence causes the IP asset to "split", and a balancing adjustment is required to be made in respect of that part of the asset which the taxpayer no longer holds. Arguably, the grantee of an exclusive licence gives away more of the asset than the grantee of a non-exclusive licence. Valuing the various parts of the IP asset is likely to be difficult, and will not only affect the balancing adjustment calculation but also any future annual deductions.
The tax consequences under the UCA of decisions relating to the creation, protection, ownership, licensing and transferring of IP are not just matters for accountants to deal with at tax time. These issues need to be understood and their consequences planned for while the commercial terms of the project or agreement are being negotiated. Understanding the UCA and related tax issues, and taking them into account when making decisions concerning IP, should lead to more tax effective business structuring.
 Labor's recently released tax policy indicates that accelerated depreciation for in-house software will be abolished if Labor wins the election.