Assessable income: amount received for the transfer of 'know-how'

Is the amount received by the taxpayer under a contract for the transfer of the information ('know-how') he was able to provide on the design of a certain machine he had invented assessable as ordinary income under subsection 6-5(1) of the Income Tax Assessment Act 1997 (ITAA 1997)?

No. The amount received under a contract for the transfer of the know-how he was able to provide on the design of a certain machine he had invented is not assessable ordinary income under subsection 6-5(1) of the ITAA 1997 because the amount is capital in nature.

A self-employed inventor (the taxpayer) had embarked upon a business venture to exploit, by means of licensing rights for royalty income or manufacture of machines for sale, certain machine designs he had invented. After encountering some difficulties in fully developing his designs and because of his advancing age, he entered into an agreement to provide the know-how on the design of the machines to a company in which he held a 10% share. To provide the know-how to the company it was necessary to transfer ownership of existing prototypes and manufacturing drawings for some of the machines and to provide drawings and assist in developing prototypes for the remaining machines where no drawings or prototypes existed.

The execution of this agreement represented a real abandonment of the taxpayer's business in regard to the know-how.

Prior to the instigation of the agreement, the taxpayer had provided information about his machine designs to other eventual shareholders in the company in an attempt to secure a licence agreement. Upon accepting the payment for the know-how, the taxpayer lost his ability to seek remedies or injunctions enforceable in equity through inappropriate use of the know-how by the other shareholders. The taxpayer, in his own right, was put out of business by entering into the agreement.

Subsection 6-5(1) of the ITAA 1997 provides that assessable income includes income according to ordinary concepts, which is called ordinary income.

Income from carrying on a business has generally been held as ordinary income.

An amount received in dealing with information in the course of carrying on a business or under an agreement for the provision of a service that involves sharing the information with another person is usually of an income nature.

In Jeffrey v. Rolls Royce Ltd [1962] 1 AER 801 (HL), the taxpayer entered into a series of agreements under which it undertook to supply drawings, manufacturing and engineering data and information required for the construction of aero engines. In respect of each agreement the taxpayer received payments of a lump sum and was entitled to receive payment of royalties. The lump sums were described as 'consideration for the rights granted', and were referred to as capital sums. The Lords found that the amounts received under the agreements were not capital in nature but represented the product of a systematic and repeated exploitation of the taxpayer's knowledge, skill and experience.

On the other hand, if the disclosing or sharing of information affects the framework of the business or causes a substantial part of the business to be lost then the amount received may be of a capital nature.

In Wolf Electric Tools Ltd v. Wilson [1969] 2 AER 724 (Ch D) ( Wolf Electric Tools ), the taxpayer carried on trade in the manufacture of electric power tools for which it had evolved production methods and a series of drawings. Although it exported to various other countries, it was unable to export to India and consequently entered into a joint venture which formed a company in India. The taxpayer held 45% of the issued shares, of which slightly more than half were in respect of the transfer of plant and machinery to enable the factory to be built, and the balance related to the supply of drawings, designs, know-how and other matters.

Pennycuick J. held that the shares allotted in respect of the transfer of know-how were not to be taken into account in computing the taxpayer's profit for income tax purposes, because they were received in return for the transfer to the Indian company of capital assets, comprising a fund of confidential material in relation to the manufacture of tools. In making his judgement he approved the dictum of Viscount Radcliffe in Musker v. English Electric Co Ltd 41 TC 556 where the latter held: ..'know-how', though very naturally looked upon as part of the capital equipment of a trade, is a fixed asset only by analogy and, as it were, by metaphor. The nature of receipts from it depends essentially, I think, upon the transactions out of which they arise and the context in which they are received. Where, as in Moriarty ( Inspector of Taxes ) v Evans Medical Supplies Ltd., 'know-how' is imparted as one element of a comprehensive arrangement by virtue of which a trader effectively gives up his business in a particular area, the moneys paid for the 'know-how', whether or not independently quantified, may properly rank as capital receipts.

Upon inventing the machine designs, the taxpayer acquired the know-how from which he would be able to earn income. This know-how formed the basis for the taxpayer's business. The taxpayer's business existed in order to exploit his know-how in the machine designs by way of licensing rights for royalty income or manufacture of machines for sale.

When the right to know-how was transferred to the other party the taxpayer ceased to carry on his business. The amount received was to compensate for the loss of his means of making profit from his know-how. The amount was received by the taxpayer in circumstances which were similar to those in the Wolf Electric Tools case and can be characterised as a receipt of capital (see also (1959) 10 TBRD Case K22 ; 8 CTBR (NS) Case 111 ).

Accordingly this amount is not assessable as ordinary income under subsection 6-5(1) of the ITAA 1997. Note In this situation CGT event C2 in section 104-25 of the ITAA 1997 happens upon the termination of the business. The amount received is the capital proceeds from the CGT event happening and a capital gain may arise.