Capital Allowances: termination value on the granting of a licence to exploit a patented invention

Is company A's undertaking to pay 50% of the revenue it earns from the exploitation of the patented invention owned by company B included in the termination value (section 40-300 of the Income Tax Assessment Act 1997 (ITAA 1997)) of part of company B's patent?

No. Company A's undertaking to pay 50% of the revenue it earns from the exploitation of the patented invention owned by company B is not included in the termination value of part of company B's patent because the undertaking is not received for the asset for the purposes of paragraph 40-300(1)(b) of the ITAA 1997.

A balancing adjustment occurs upon company A entering into a licence agreement with company B. The licence permitted company A to exploit, in a foreign jurisdiction, the technology, patents and know-how owned by company B in an invention. Under the licence company A was obliged to pay 50% of the revenue it earned from exploiting all of the technology patents and know-how owned by company A in the foreign jurisdiction. The royalty is payable monthly in arrears and was negotiated at arm's length. Company A was not required to pay any amount either as prepaid royalties or as consideration for entering into the licence agreement.

The licence agreement contains provision for company A to sublicense authority to other parties to exploit the patented invention and for company B to terminate the agreement and any sub licences granted upon certain acts or omissions by company A. Failure by company A to pay the required royalty amounts is included in the agreement as a termination event.

A balancing adjustment event will occur if a taxpayer stops holding part of a depreciating asset (note in subsection 40-295(3) of the ITAA 1997). A balancing adjustment is required if the taxpayer worked out or would have worked out a decline in value for the asset under Subdivision 40-B of the ITAA 1997 (section 40-285 of the ITAA 1997).

For the purposes of working out a balancing adjustment under section 40-285 of the ITAA 1997, the termination value of a depreciating asset has the meaning given by section 40-300 of the ITAA 1997. Section 40-300 provides that the termination value of a depreciating asset is, in certain cases, an amount specified in the table in subsection 40-300(2) of the ITAA 1997. Where those cases do not apply, paragraph 40-300(1)(b) of the ITAA 1997 states that the termination value is the amount under section 40-305 of the ITAA 1997 that you are taken to have received for the asset. The termination value is worked out at the time when the balancing adjustment event occurs.

In the present case, a balancing adjustment event occurs when company B enters into the licence agreement with company A. No amount specified in the table in subsection 40-300(2) of the ITAA 1997 applies. Section 40-305 of the ITAA 1997 treats certain benefits (set out in the table in paragraph 40-305(1)(b) of the ITAA 1997), including non-cash benefits, as having been received for the asset under the balancing adjustment event.

Company B does not receive, nor is it entitled to receive, any money as a result of the actual licensing transaction with company A. Instead company B is entitled to royalties of 50% of the revenue company A gains when using the licence. A right to income carries attributes associated with property and therefore is potentially within the meaning of the term 'non-cash benefit' as defined in subsection 995-1(1) of the ITAA 1997. However, even though the right to income may be a non-cash benefit, the issue is whether this non-cash benefit is an amount company B is taken to have received under section 40-305 of the ITAA 1997 for the asset.

In order for an amount to be included in termination value, section 40-300 of the ITAA 1997 requires a necessary connection between the relevant amount in the table in paragraph 40-305(1)(b) of the ITAA 1997 and the depreciating asset. It is reasonable to conclude that company A's undertaking to pay royalties relates to the exploitation of the patent and thus is a promise to pay for the exploitation of the invention during the period the agreement remains in force. The agreement can be terminated upon certain acts occurring including a failure by company A to pay royalties.

Company A does not pay an amount for entering into the licence agreement, and the royalties do not contain any embedded capital amount. Therefore, whilst the right to the royalty is 'property' for the purposes of the definition of a 'non-cash benefit' as it relates to item 4 in the table in paragraph 40-305(1)(b) of the ITAA 1997, it is not property the taxpayer is taken to have received under section 40-305 of the ITAA 1997 for the asset.