What is Intellectual Property?
Intellectual property IP encompasses a range of intangible assets and rights held by a taxpayer. This includes rights held by a taxpayer as the owner or licensor of patents, registered designs, copyrights and so forth.
The definition of intellectual property under taxation law differs from the general law definition. The tax law definition is narrower and excludes trademarks, trade secrets, customer lists, confidential information and domain name rights. This article will separately address the tax treatment of IP which satisfies the tax law definition of IP (we will refer to this as Tax IP) and IP which falls outside this definition.
It is worth briefly defining some of the various forms of IP. A trademark involves a legal protection for exclusive rights over a sign used to distinguish goods or services. This could include a letter, label, symbol etc.
A patent involves legal protection for exclusive rights over the use and exploitation of an invention. The rights afforded generally last for 20 years or 6 years in respect of a petty patent.
A registered design involves legal protection for particular unique and new designs. For example, the visual appearance of a manufactured item. A copyright involves exclusive rights over original material. For example, musical work, artwork, or literary works.
Is IP expenditure deductible?
IP expenditure is deductible when incurred under section 8-1 of the Income Tax Assessment Act 1997. This is provided the necessary connection exists between the expenditure and the assessable income producing activity and the expense is of a revenue or private nature.
The taxation treatment of outgoings related to the acquisition and development of the item of IP will vary depending on the classification of the IP as either trading stock, a revenue asset that is not trading stock, as a depreciable asset on capital account or as a non depreciable asset on capital account.
The cost to acquire and develop Tax IP and non Tax IP for the purpose of re sale in the ordinary course a business of trading in IP assets may be treated as trading stock. The costs incurred to acquire the trading stock will be deductible once the stock is on hand.
Remember that trading stock is defined as anything produced, manufactured or acquired that is held for the purposes of manufacture, sale or exchange in the ordinary course of business.
Revenue account outgoing
The cost to acquire and develop Tax IP and non Tax IP associated with a taxpayer’s day to day occupation is generally considered revenue in nature and deductible under section 8-1 of the ITAA. This is despite the fact the production work eventually creates an asset subject to copyright. For example, costs incurred by an academic drafting a textbook may be deductible even though the completed and published textbook is subject to copyright protection.
Tax IP that is not trading stock or on revenue account is a depreciating asset. The non revenue expenditure to acquire or develop the IP item can be amortised / depreciated by the holder of the asset over the effective life of the asset under the capital allowances regime.
It is the holder of the asset that will be entitled to the depreciation deduction for the capital expenditure incurred in respect of an item of IP. Note that not all costs related to the IP asset will be added to the cost of the asset. For example, certain day to day expenses (revenue expenses) related to the IP may be immediately deductible under section 8-1 (or another provision) instead of being added to the cost of the IP asset that is depreciated.
The depreciation deduction for the decline in value of the tax IP only commences when the asset comes into a marketable form (therefore, expenditure incurred on IP may not immediately yield a depreciation deduction for the taxpayer). This generally occurs at the point in time when the Tax IP item is in such a condition to generate income for the taxpayer. However, it is not always strictly necessary that there is a direct connection between the use of the IP asset and the generation of assessable income. The use of the IP within a broader business structure may be sufficient.
Unless the small business depreciation incentives are applied, the depreciation deduction for the decline in value of the Tax IP asset will occur gradually over the effective life of the Tax IP asset. The depreciation deduction for the decline in value must be calculated using the prime cost (straight line) method. The taxpayer is not permitted to use the diminishing value method to accelerate or front load depreciation deductions. The taxpayer, unlike with most other depreciable assets, is not afforded the right to self assess the effective life of a Tax IP asset. Rather, the effective life determined by the Commissioner of Taxation must utilised. The effective life of various classes of intangible depreciating assets is set out in the below.
- Standard patent = 20 years
- Innovation patent = 8 years
- Petty patent = 6 years
- Registered design = 15 years
- Copyright = the lesser of 25 years from acquisition and the end date of the copyright.
- A licence (not in relation to copyright or in house software) = the term of the licence.
- A licence relating to copyright (except in relation to a film) = the lesser of 25 years from acquisition or copyright and the end date of the licence.
- In house software = 5 years
As an example of depreciation in action, take Abbie who carries on a business and obtains a standard patent for $100,000. Abbie can claim an annual depreciation deduction of $5,000 (i.e. $100,000 / 20 years) per year over 20 years.
If the taxpayer is eligible and opts to utilise the small business depreciation concessions, the taxpayer may be in a position to claim immediate depreciation provided the tax IP is not held on revenue account. The immediate depreciation will only be available if the asset value is under the relevant cost threshold at the time it is acquired and first ready for use. The small business depreciation concessions have changed over time. Therefore, the relevant thresholds and eligibility criteria should be confirmed according to the depreciation rules and incentives in place at the relevant time.
Note that an immediate deduction is available to businesses where the cost of the Tax IP asset does not exceed $100.
Also note that if Tax IP is used for a private purpose, the private percentage may not be claimed as a depreciation deduction. In fact, CGT event K7 and a capital gain may flow in response to the private use of the asset.
Non depreciable capital asset
As mentioned, IP which is not tax IP (e.g. goodwill, trademarks, domain name rights and business name rights) and which is held on capital account will not be a depreciable asset. Rather, it will be classified as a CGT asset. Depending on the relevant CGT event, the costs incurred to acquire or develop the asset may be added to the cost base of the IP asset. The CGT discount and Small Business CGT concessions may also be available for the taxpayer to reduce gains on the disposal of the IP. Of course, the eligibility criteria for these concessions must be satisfied.
Note that any IP related capital costs which are not deductible and not included in the cost base of the CGT asset may be deductible to a business over five years as a blackhole expense under section 40 880 of the ITAA.
Tax consequences on the disposal (not assignment) of the depreciating asset
Depreciating assets are subject to the balancing adjustment rules. If a balancing adjustment event occurs (e.g. where the asset is disposed, expires or ceases to exist) the excess of the termination value (i.e. sale proceeds) over the adjustable value (i.e. tax value) results in assessable income. Conversely, where the adjustable value exceeds the termination value, a deduction for the excess will be permitted. Common examples of balancing adjustments in the context of Tax IP might include the following:
- Where the relevant legal protection ceases to exist because the protection over the item ceases e.g. the expiry of a patent.
- Where the whole IP asset is disposed.
- Where there is a surrender of a licence.
- Where the item is subject to partial ownership change.
Note that the renewal or extension of a right under a patent, design, copyright or licence does not trigger a balancing adjustment event. There is simply a continuation of the original right.
Note also the potential availability of various rollovers to defer tax on the disposal of the Tax IP.
Entitlement to a deduction for the payment of rights to use IP?
Taxpayers who make periodic payments to utilise the IP of another as part of a business or in producing assessable income will usually be entitled to a deduction for those payments under section 8-1 of the ITAA. The payment may constitute a royalty payment meaning withholding tax obligations may arise if the IP provider is a non resident.
Is income derived from IP assessable?
IP which is traded in the ordinary course of a taxpayer’s business will generally be considered trading stock and assessable income to the taxpayer when disposed and no longer on hand to the taxpayer.
Income derived by taxpayers from the use and exploitation of IP assets will generally be ordinary income and assessable under section 6-5 of the ITAA.
If the income derived fails to meet the definition of ordinary income there are specific statutory provisions in section 6 of the ITAA 1936 and section 15-20 of the ITAA which treat that income as assessable royalty income. The definition of royalties includes:
any amount paid or credited, however described or computed, and whether the payment is periodical or not, to the extent to which it is paid or credited, as the case may be, as consideration for: the use of, or the right to use, any copyright, patent, design or model, plan, secret formula or process, trade mark, or other like property or right…
Research and Development Incentives
To explain, a tax offset is equally as valuable as cash (e.g. $1 tax offset equals $1 cash in value) whereas a deduction merely applies against assessable income to produce the taxpayer’s taxable income, which is then multiplied by the applicable tax rate to determine the tax payable or refundable to the taxpayer (e.g. a $1 tax deduction may equal between $0 and $0.45c in value depending on the applicable tax rate). The inner workings of the research and development tax incentive will be address in another article.
This article is for general information only. It does not make recommendations nor does it provide advice to address your personal circumstances. To make an informed decision, always contact a registered tax professional.