Income tax: licence arrangements for intellectual property - Division 40 tax avoidance schemes

This Ruling examines schemes connected with intellectual property. Specifically, it examines tax benefit transfer arrangements under which taxpayers, with limited or no financial exposure to the success or failure of the commercialisation of the intellectual property, enter into contrived arrangements to obtain the benefit of deductions from developers of intellectual property who cannot benefit directly under Division 40 of Part 2-10 of the Income Tax Assessment Act 1997 ('ITAA 1997'). These arrangements distort the tax concession intended by Division 40 and are considered to be tax avoidance schemes.

This Ruling does not deal with arrangements where the real risks and benefits of ownership are acquired in respect of the intellectual property.

The conclusions reached in this ruling in relation to the application of Division 40 also apply to arrangements entered into: • prior to 22 June 1998 where deductions are claimed under Division 10B of Part III of the Income Tax Assessment Act 1936 ('ITAA 1936'); and • prior to 30 June 2001 where deductions are claimed under Division 373 of Part 3-45 of the ITAA 1997. Comparison and Conversion Table Division 40 Division 373 Division 10B ITAA 1997 ITAA 1997 ITAA 1936 40-25(1) and 40-30(2)(c) 373-5 68A 40-25(1) and 40-30(2)(c) 373-10(1) 124L, 124M(1) 40-25(2) 373-5(2) 40-30(1) 40-40 40-40 item 7 40-70(3) and 40-75 373-20(1) 124M(1) 40-70(2) and 40-75 373-20(2) 124M(5), (6) 40-75(7) 40-85 373-25 40-85(1) 373-25(1), (2)(a) 124S(1)(a) 40-85(1)(a) 373-25(2)(b) 124S(1A) 373-25(3) No equivalent 40-95(7), item 6 373-35 124U(1), (2) 40-115(2) and (3) 373-45 to 373-55 40-180 373-30 124R(1) - (5) 40-180(2) item 8 373-80, 373-100 40-285(1) and (2) 373-60(1), 373-65 124M(5), 124N, 124P(1), 124V(2)(a), 124W(1), (2) 373-65(1) 124N, 124P(1) 373-65(2) 124P(1), (3) 373-65(3) 124N, 124Z 373-65(4) No equivalent 40-295(3) 373-60 (2) 124M(5), 124N, 124P(1), 124V(2)(a), 124W(1), (2) 40-300 373-70 373-70(1), 373-70(2) 124T(1), (2), 124W(3), 124T(3)

This Ruling applies to persons who enter into or carry out an arrangement having essentially the following features: • A special purpose partnership ('the partnership') is established to acquire from a developer a licence to use and commercialise existing intellectual property; • A special purpose company is established and appointed nominee and manager of the partnership; • Each investor in the partnership borrows funds from a financier under a capitalising debt facility established for all investors; • The funds borrowed, together with the funds provided by each investor from their own resources, are used to make a contribution to the partnership of: - a nominal amount of equity; - an interest bearing debt advance ('IBD'); and - a non-interest bearing debt advance ('NIBD'). • The amount of the IBD equates to the value of the funds borrowed under the capitalising debt facility; • Interest accrues and is capitalised on the IBD on the same basis and at the same rate as interest accrues and is capitalised on the borrowed funds; • The contributions are used by the partnership to acquire the licence and to finance the commercialisation; • Under a licence agreement the partnership acquires from the developer an exclusive licence to use, develop, exploit and commercialise the intellectual property for an agreed period. Beyond the licence period, the partnership may benefit from the exploitation of application results through licensing or through realising the value contained in them; • The developer places the licence acquisition amount on deposit with the financier to be held as security for the funds borrowed by the investor; • Interest which accrues on the security deposit is equal to the interest accruing under the capitalising debt facility; • The balance of the security deposit account cannot be less than the amount outstanding under the debt facility; • Under a commercialisation agreement, the partnership grants the developer an exclusive right to use the intellectual property for the period of the licence; • As consideration, the developer agrees to pay as royalty income the greater of an agreed minimum amount per annum and a percentage of gross marketing income from the commercialisation proceeds; • The developer undertakes an agreed development and commercialisation program on behalf of the partnership for a fee which is paid in advance; • As further security for the funds borrowed by the investors, the partnership is required to deposit 50% of the royalty income into a royalty deposit account, held in the name of the partnership, with the financier; • The financier's recourse to the investors is limited to the amount of the royalty deposit account and the investors' interest in the partnership assets; • Both the partnership and the developer provide cross guarantees and indemnities; • The partnership, the developer and an associate of the developer enter into an option agreement, under which a put option is granted to the partnership and a call option is granted to the developer; • Upon the exercise of the put option the developer is required to become a partner with a partnership share of 75% and pay a contribution to the partnership; • Upon the exercise of the call option, the developer becomes a partner, and pays a contribution to the partnership; • The contribution consists of a nominal amount of equity and an additional amount representing the balance of the IBD less the balance of the royalty deposit account; • The additional contribution is funded by the amount held in the security deposit account; • The additional contribution is distributed to the investors and applied in repayment of the funds borrowed under the capitalising debt facility; • After the exercise of the put or call options, the investors may exercise an exit option requiring the associate of the developer to acquire their remaining interests in the partnership; • The associate is required to pay the greater of an agreed minimum price and 25% of the market value of the partnership assets; and • All agreements are entered into on the same day and have effect on the same day.

The following diagram illustrates the key features of a typical arrangement.

As the minimum investment required in these types of arrangements is at least $500,000 they are marketed to investors with relatively high personal income.

This Ruling also applies to persons who enter into or carry out the following arrangement: • A company, trust, partnership or individual acquires rights as owner, licensee, or patentee, in relation to intellectual property for the purposes of Division 40; • the rights are realised or partially realised by transfer, sublicense, or exploitation by the developer, or an associate of the developer. This is achieved by way of: - an assignment; - a commercialisation agreement, or otherwise, either immediately or soon after the rights are acquired; or - a put and/or call option (or an embedded put and/or call option) in respect of the rights that it is reasonable to assume will be exercised, is granted to or by the developer, or an associate of the developer, either immediately or soon after the rights are acquired. • The company, trust, partnership, individual, or an associate, obtains finance either directly or indirectly from the developer or an associate of the developer, or a guarantee from the developer or an associate of the developer and the finance represents the substantial part of the price of acquiring the rights; • The net income reasonably expected to be derived from the commercialisation program by the company trust or partnership, or by the shareholders, partners, or beneficiaries, or by those ultimately interested therein, will be less than the value to them of the tax benefits obtained by them under the arrangements; and • The combined effect of the loan and guarantee arrangements and the tax saving ensures there is limited or no financial exposure associated with the investment.

Whilst the Ruling is based on the arrangement identified in paragraph 4, the principles also apply to the arrangement identified in paragraph 7.

Division 40 enables the holder of a depreciating asset, held for any time during the year, to deduct an amount equal to the decline in value for an income year (subsection 40-25(1)). The deduction is reduced by the part of the asset's decline in value that is attributable to the use of the asset for a purpose other than a taxable purpose (subsection 40-25(2)).

Usually, the owner of a depreciating asset holds the asset and can therefore claim deductions for its decline in value. Sometimes the holder of a depreciating asset is its economic owner (section 40-40).

A depreciating asset is an asset that has a limited effective life and can reasonably be expected to decline in value over the time it is used and specifically includes, as an intangible asset, items of intellectual property (subsection 40-30(1) and paragraph (2)(c)).

An item of intellectual property consists of the rights (including equitable rights) that an entity holds under a Commonwealth law as: (a) the patentee, or a licensee, of a patent; (b) the owner, or a licensee, of a registered design; or (c) the owner, or a licensee, of copyright; or of equivalent rights held under a foreign law (subsection 995-1(1)).

The partnership is never the holder of the item of intellectual property for any time during the year. Therefore, Division 40 has no application to the partnership.

The licence agreement and the commercialisation agreement simultaneously transfer the rights from the developer to the partnership and then back to the developer. There is never a measurable period of time during which the partnership holds the rights. The integrated nature of the licence and commercialisation agreements has the effect that the developer retains effective possession and control of the item of intellectual property.

Alternatively, if the partnership does become the holder, the deduction under subsection 40-25(1) is based on the cost of the intellectual property at the time the partnership acquired the item. The 'cost' is the market value of the item of intellectual property at the time the partnership acquired the item under the licence agreement as the parties are not dealing at arm's length in relation to the acquisition (subsection 40-180(2) table item 8). The financing arrangements, the guarantees and the put and call options show that the relevant parties to these arrangements are not dealing at arm's length in respect of the item of intellectual property.

If the partnership becomes the holder, the partnership immediately disposes of all of its rights to use, develop, and exploit the item of intellectual property under the commercialisation agreement. In particular, the transfer of the licence back to the developer for the purpose of commercialisation constitutes a disposal of all of the rights.

Where there has been a disposal of the item of intellectual property the partnership has stopped holding the asset. A balancing adjustment event occurs (section 40-295) and a balancing adjustment is required (section 40-285). The balancing adjustment is the difference between the value of the asset when the partnership stopped holding the asset (the termination value) (section 40-300) and the value just before the partnership stopped holding the asset (the adjustable value) (section 40-85). If the termination value is more than the adjustable value the difference is included in assessable income (subsection 40-285(1)) and if the termination value is less than the adjustable value a deduction is allowed (subsection 40-285(2)).

Where there has been an immediate disposal, the adjustable value of the item of intellectual property (paragraph 40-85(1)(a)) equals the cost paid by the partnership - the market value (refer paragraph 15 above). The termination value (section 40-300) of the item of intellectual property is worked out at the time the balancing adjustment event occurs. The termination value is the market value of the asset just before the partnership stopped holding the asset (subsection 40-300(2), table item 6). The market value cannot change between the time of acquisition and the immediate disposal of the rights. Therefore no amount is deductible or assessable under subsections 40-285(1) and (2).

Alternatively, if there has been an immediate partial disposal of the item of intellectual property by way of the grant of an exclusive licence the partnership has stopped holding part of the asset (subsections 40-115(2) and (3)), and therefore a balancing adjustment event also occurs (subsection 40-295(3)). In the case of a partial disposal of the rights, the adjustable value of the item of intellectual property (paragraph 40-85(1)(a)) equals the cost paid by the partnership - the market value (refer paragraph 15 above). The termination value (section 40-300) of the item of intellectual property is worked out at the time the balancing adjustment event occurs. The termination value is the market value of the asset just before the partnership stopped holding the asset (subsection 40-300(2), table item 6). The market value cannot change between the time of acquisition and the immediate disposal of the rights. Therefore no amount is deductible or assessable under subsections 40-285(1) and (2).

Section 82KL of the ITAA 1936 applies to the arrangement to deny any deduction as the expenditure is 'eligible relevant expenditure' incurred as part of a 'tax avoidance agreement' and the expenditure is effectively recouped under the arrangement.

The amount paid by the taxpayers to acquire the item of intellectual property is eligible relevant expenditure (subsection 82KH(1F) and paragraph 82KH(1)(wa).

These arrangements constitute a 'tax avoidance agreement' under subsection 82KH(1) for the purposes of section 82KL.

An arrangement which involves deductible expenditure by a taxpayer being financed wholly or partly by a loan which will be effectively repaid by another person is a 'recoupment arrangement'. An amount recouped under a recoupment arrangement is an additional benefit (subsection 82KH(1) and subsection 82KH(1F)).

Under these arrangements a loan is obtained by each investor to finance the acquisition of the item of intellectual property. The loan is effectively guaranteed by the developer. The effect of the various agreements is such that it is reasonable to expect that: • the partnership will not have to repay the whole or a part of the loan prior to the put or call option being exercised; • put and call options will be exercised while the debt remains outstanding; and • the security deposit will be relied upon to enable repayment of the outstanding debt.

The tax saved by the investor through the partnership loss is an expected tax saving (subsections 82KH(1) and (1B)).

Under the put and call options the developer becomes a partner in the partnership. As a result of the exercise of the put or call option the developer contributes an amount equal to the IBD. Section 82KL will apply to disallow the deductions claimed where the amount payable by the developer plus the expected tax saving equals or exceeds the amount of the deductions.

Expenditure on commercialisation fees, interest on borrowings and other fees is allowable only to the extent of income received in each year of the arrangement.

The arrangements have a number of features which achieve the following results: • the lack of any financial risk to the investor; • the obtaining of a profit by the investor regardless of the success or otherwise of the commercialisation program; and • tax savings to the investor in excess of the cost to the investor of participating in the scheme.

Having regard to the eight factors in paragraph 177D(b) a reasonable person would conclude that the sole or dominant purpose for a person or persons entering into or carrying out the scheme is to enable the investors to obtain a tax benefit.

Therefore, Part IVA will apply to deny the deductions claimed.

This Ruling applies to years of income commencing both before and after its date of issue.

This Ruling does not apply to taxpayers to the extent that it conflicts with the terms of a settlement of a dispute agreed to before the date of issue of the Ruling (see paragraphs 21 and 22 of Taxation Ruling TR 92/20).

Division 40 of the ITAA 1997 provides a set of general rules (in subdivision 40-B) to calculate the deduction to taxpayers for the notional decline in value of most depreciating assets they hold. A depreciating asset is broadly defined in section 40-30 as being an asset that has a limited effective life and can reasonably be expected to decline in value over the time it is used. Some types of intangible assets are depreciating assets to the extent that they are not trading stock. Items of intellectual property are one such intangible asset that is specifically included in the definition of depreciating asset.

Under subsection 40-25(1) an entity can deduct an amount equal to the decline in value for an income year of a depreciating asset that they held during the year. Usually, the owner of a depreciating asset holds the asset and can therefore claim deductions for its decline in value.

Property which has become 'partnership property' or a 'partnership asset' at general law is beneficially owned by all of the partners, even if only one partner is the legal owner. Thus, the partnership, and not any individual partner, is regarded as holding the asset (section 40-40, table item 7).

Subdivision 40-C defines the cost of a depreciating asset on which the deductions under subdivision 40-B are based. Where a taxpayer becomes the holder of a depreciating asset under an arrangement in which they did not deal at arm's length with one or more of the other parties to that arrangement and paid (or are taken to have paid) more than the market value of the asset, the cost is the market value of the asset when they started to hold it (subsection 40-180(2), table item 8).

Effective life varies for different types of intellectual property. It is generally linked to the period for which the intellectual property rights subsist under the relevant Commonwealth law.

Sections 40-70 and 40-75 contain the general rules for working out the decline in value of depreciating assets. Under the prime cost method (the method which must be used for items of intellectual property), for any year after the first (in which the prime cost formula ensures that no more than cost can be claimed) the decline is limited to the opening adjustable value (the cost remaining after the previous year's decline) (subsections 40-70(3) and 40-75(7)). The effective life of an item of intellectual property acquired under a licence is the term of the licence (subsection 40-95(7) table item 6).

Balancing adjustments (section 40-285) must be made when: • a taxpayer stops holding a depreciating asset; • a taxpayer stops using a depreciating asset for any purpose and expects never to use it again; • a taxpayer has not used a depreciating asset and expects never to use it; or • there is a change in the holding of, or in the interest of entities in the asset, and one of the entities that have an interest after the change, held the asset before the change.

In these cases, the adjustable value (section 40-85) of the asset is compared with its termination value (section 40-300). If the termination value is higher, the adjustable value (which reflects past decline and original cost) is below the actual value, and the difference generates a balancing charge for inclusion in income (subsection 40-285(1)). If the termination value is lower, the adjustable value is above the actual value, and the difference generates a balancing deduction against income (subsection 40-285(2)).

An entity that acquires rights as licensee is the holder of an item of intellectual property. An entity that has used an item of intellectual property for the purpose of producing assessable income can deduct an amount for a year of income (subsection 40-25(1) and paragraph 40-30(2)(c)). However, an entity cannot deduct an amount if they have not held the depreciating asset for any time during the year. In our view, the various agreements outlined at paragraph 4, have the effect of ensuring that the partnership is never the holder of an item of intellectual property and Division 40 does not apply.

Under the arrangements, the original owner (the developer) retains its proprietary rights in the intellectual property and grants an exclusive licence to the partnership to use, exploit and commercialise the intellectual property. The partnership, being the licensee, then contracts with the original owner to commercialise the intellectual property by immediately sub-licencing the intellectual property back. Whilst the sub-licence is not exclusive, the licensee agrees not to licence the intellectual property to anyone other than the original owner.

Under the terms of the licence agreement the legal title remains with the developer. The effect of the agreements is that the developer does not surrender effective possession or control of the rights in respect of the item of intellectual property.

Where an investor is not exposed to any downside risk due to a combination of indemnities, guarantees and put options it can be argued that in no real sense is the investor sufficiently the owner or licensee for the purposes of Division 40.

At all times the developer maintains effective possession and control of the item of intellectual property, the partnership is never the holder of a depreciating asset and Division 40 has no application to the partnership.

Alternatively, if the partnership did become the holder of an item of intellectual property, the deduction under subsection 40-25(1) is based on the cost of the intellectual property at the time the partnership acquired the item. The 'cost' is the market value of the item of intellectual property at the time the partnership acquired the item under the licence agreement as the parties are not dealing at arms length in relation to the acquisition (subsection 40-180(2) table item 8).

The integrated nature and terms of the various agreements entered into indicate that the parties to the arrangements are not dealing at arm's length in relation to the acquisition, use and exploitation of the item of intellectual property by the partnership and the licensing back of the item.

In these arrangements the parties are not dealing with each other at arm's length (notwithstanding that they are otherwise unconnected parties) for the following reasons: • the terms of the contractual and financing arrangements effectively eliminate any adverse commercial consequences; • the debt borrowed from the financier to fund the intellectual property licence is never at risk because of the various put/call/exit options which pay out the borrowings plus interest; • funds are borrowed by the investors from the financier under a facility which was set up on their behalf; • the security deposit plus the accrued interest on the security deposit and the amount in the royalty account equates to the amount required to pay out the debt facility; • the licence fee is paid into the deposit account by the licensee at the direction of the developer; • the provision of the guarantee and indemnity by the developer to the financier secures the capitalising debt facility of the investors; • the developer takes responsibility for any costs or losses incurred by the financier under the facility agreement; • although the partnership owns the application results which arise from the commercialisation of intellectual property it is the developer who must pay to protect these results; • the partnership is indemnified under the licence agreement against any loss arising from the use of the intellectual property; and • the exit option guarantees that investors' funds are not at risk.

If the licence agreement does constitute an acquisition of an item of intellectual property so that the partnership becomes the holder of a depreciating asset, the commercialisation agreement amounts to a disposal of all of the rights possessed by the partnership in the item of intellectual property. Whilst the licence agreement transfers that right to the partnership, the commercialisation agreement immediately transfers effectively the same rights to the developer. The developer is the grantor of the licence under the licence agreement and at the same time the developer is the recipient of a virtually identical set of rights under the commercialisation agreement. The developer becomes the holder for the purposes of Division 40.

Where there has been a disposal of the item of intellectual property the partnership has stopped holding the asset, a balancing adjustment event occurs (section 40-295) and a balancing adjustment is required (section 40-285). The balancing adjustment is the difference between the value of the asset when the partnership stopped holding the asset (termination value) and the value just before the partnership stopped holding the asset (adjustable value). If the termination value is more than the adjustable value the difference is included in assessable income (subsection 40-285(1)) and if the termination value is less than the adjustable value a deduction is allowed (subsection 40-285(2)).

If the rights in relation to the item of intellectual property are disposed of in whole a balancing adjustment event occurs (section 40-295). A balancing adjustment (section 40-285) is required when a balancing adjustment event occurs. Subsections 40-285(1) and (2) allow a deduction if the termination value is less than the adjustable value. The adjustable value is the cost paid by the partnership - the market value. The termination value is determined in accordance with section 40-300.

Based on the matters referred to in paragraphs 47 and 48 above, the parties are not dealing at arm's length in relation to the disposal of the rights under the commercialisation agreement. Where the partnership grants the licence to the developer under the commercialisation agreement, the termination value will be the market value of the item of intellectual property at the time the partnership stops holding the asset. The value of the item of intellectual property to the partnership at the time of its disposal under the commercialisation agreement will be the adjustable value (subsection 40-85(1)). As the value of the partnership's rights in relation to the licence does not change between the time of its acquisition under the licence agreement and its immediate disposal under the commercialisation agreement, the termination value on disposal will be the market value at the time that the partnership stopped holding the asset.

Alternatively, if it is found that there has not been a disposal in whole, the commercialisation agreement has the effect of making the developer 'a licensee of a patent or copyright' for the purposes of the definition of a holder in section 40-40 table item 6 and therefore entitled to claim a deduction under subsection 40-25(1). The commercialisation agreement will constitute a disposal in part.

If the commercialisation agreement does constitute a disposal in part of the partnership's rights in relation to the patent or copyright, there has been a disposal because the partnership has stopped holding part of the asset (subsections 40-115(2) and (3). In such a case a balancing adjustment event occurs (subsection 40-295(3)) and a balancing adjustment is required (section 40-285). The balancing adjustment is the difference between the value of the asset when the partnership stopped holding part of the asset (termination value) and the value just before the partnership stopped holding the asset (adjustable value). If the termination value is more than the adjustable value the difference is included in assessable income (subsection 40-285(1)) and if the termination value is less than the adjustable value a deduction is allowed (subsection 40-285(2)). In these arrangements where linked simultaneous transactions occur, involving the acquisition of an asset and the effective immediate disposal of part of the asset constituting the whole value of the asset, the value of what is acquired and the value of what is disposed of cannot be different.

Section 82KL of the ITAA 1936 is a specific anti-avoidance provision that operates to deny an otherwise allowable deduction for certain expenditure incurred by the taxpayer, but effectively recouped. Under subsection 82KL(1), a deduction for 'eligible relevant expenditure' is disallowed where the sum of the 'additional benefit' plus the 'expected tax saving' in relation to that expenditure equals or exceeds the 'eligible relevant expenditure'.

The cost of an item of intellectual property which is deductible under Division 40 is 'relevant expenditure' and may be 'eligible relevant expenditure'. 'Eligible relevant expenditure' (subsection 82KH(1F)) is 'relevant expenditure' incurred under a tax avoidance agreement where, under the tax avoidance agreement, the taxpayer (or an associate) obtains an 'additional benefit'.

A 'tax avoidance agreement' for the purposes of section 82KL means 'an agreement that was entered into or carried out for the purpose, or for purposes that included the purpose, of securing that a person who, if the agreement had not been entered into or carried out ... would not be liable to pay income tax ... or would be liable to pay less income tax ...'.

An 'agreement' for the purposes of section 82KL means 'any agreement, arrangement, understanding or scheme ...'. The arrangements described in paragraphs 4 and 7 constitute an agreement.

Subsection 82KH(3) provides that 'an agreement shall be taken to have been entered into or carried out for a particular purpose, or for purposes that included a particular purpose, if any of the parties to the agreement entered into or carried out the agreement for that purpose, or for purposes that included that purpose, as the case may be'.

A tax avoidance purpose will be present where features of the kind outlined in paragraph 28 above are found.

'Additional benefit' (see the definition of 'additional benefit' at subsection 82KH(1) and paragraph 82KH(1F)(b)) is, broadly speaking, a benefit received which is additional to the benefit for which the expenditure is ostensibly incurred.

In these arrangements there are at least two possible additional benefits: (a) The partnership will not have to repay the whole or a part of the loan prior to the put or call option being exercised; and (b) The investors will not have to repay the whole or a part of the loan prior to the put or call option being exercised.

The above are additional benefits because the benefits do not arise in relation to the relevant expenditure (incurred under the licence agreement). The option agreements enable the investors' loan obligations to be discharged without recourse to the investors' own funds. These are part of the tax avoidance agreement.

For the purposes of the expression 'the amount or value of the additional benefit' in section 82KL, 'amount' refers to the face value of an additional benefit expressed in monetary terms, and value refers to the monetary value of property not expressed in monetary terms. The additional benefits referred to in paragraph 62 above are expressed in monetary terms. Accordingly, it is the face value that is the relevant amount of the additional benefit, not the market value or net present value.

The 'expected tax saving' (see the definition of 'expected tax saving' at subsections 82KH(1) and 82KH(1B)) is essentially the tax saving obtained by the taxpayer or another person if a deduction is allowed for the eligible relevant expenditure. The expected tax saving of the investors in the partnership is: (a) the amount of tax the investors would pay if the deductions were not allowable to the partnership (and therefore no entitlement to a deduction for a share of the loss would arise); less (b) the amount of tax the investor would be liable to pay if the deductions were allowable to the partnership.

Section 82KL will apply to disallow the deductions claimed where the amount payable by the developer (or the amount of the unpaid loan at the time when the option is exercised) plus the expected tax saving equals or exceeds the amount of the deductions.

Subsection 82KL(1) applies where the relevant events have occurred. However, subsection 82KL(2) allows the Commissioner to apply section 82KL to disallow a deduction where the relevant events may not have occurred but the Commissioner is satisfied that section 82KL might reasonably be expected to operate at a later time, the sum of the 'additional benefit' and the tax saving will exceed the eligible relevant expenditure. It is reasonable to expect that the partnership will rely on the option agreement to repay the loan obligations and therefore the additional benefit will be obtained.

Where the Commissioner has applied subsection 82KL(2), but later is satisfied that the particular circumstance relied upon to disallow the relevant deduction will not eventuate, the Commissioner will amend the assessment to allow a deduction for the expenditure (subsection 82KL(3)).

Subsection 170(10) enables the Commissioner to give effect to section 82KL by amending assessments of taxpayers at any time.

Under the terms of the arrangement the partnership incurs expenditure for commercialisation fees, interest on borrowings and other fees.

The partnership sub-licenses the intellectual property in exchange for the royalties and pays the developer commercialisation fees to maximise the potential income (royalty) stream.

For the deductions to be allowable under section 8-1 of the ITAA 1997 there must be a reasonable expectation of income and not a mere theoretical possibility. In the arrangement described at paragraph 4 the partnership derives the guaranteed minimum royalty in each year. The arrangement will only be profitable if the commercialisation program exceeds business plan projections. In our view, there is only ever a mere theoretical possibility, rather than a reasonable expectation, of additional royalty income.

The decision in Fletcher & Ors v. FC of T 91 ATC 4950 makes clear that, in a case where there is an apparent disproportion between the detriment of the outgoing and the benefit of the income, the problem of characterisation of the outgoing needs to be resolved by a weighing of the various aspects of the whole set of circumstances, including direct and indirect objects and advantages which a taxpayer seeks to achieve in making the outgoing. It is a commonsense or practical weighing of all factors which will provide the ultimate answer. At ATC 4958, their Honours noted that: "......if, however, that consideration reveals that the disproportion between outgoing and relevant assessable income is essentially to be explained by reference to the independent pursuit of some other objective and that part only of the outgoing can be characterised by reference to the actual or expected production of assessable income, apportionment of the outgoing between the pursuit of assessable income and the pursuit of that other objective will be necessary."

In Fletcher the deduction was limited in each year to the amount of income derived in that year because the disproportion in that year was not explainable by reference to surplus assessable income which was expected to be derived in subsequent years. In the arrangement described at paragraph 4 a minimum royalty will be derived in each year. However, in our view there is only a remote possibility of any additional income being derived.

The common sense weighing of the circumstances would mean that deductions claimed under section 8-1 of ITAA 1997 for commercialisation fees, associated interest outgoings and other fees be limited to the extent of the income returned.

For the general anti-avoidance provisions of Part IVA of the ITAA 1936 to apply, there must be a 'scheme' (section 177A) and a 'tax benefit' (section 177C) and it must be concluded that the scheme was entered into or carried out by a person or persons for the sole or dominant purpose of enabling the relevant taxpayer to obtain the tax benefit (section 177D). See, generally, FC of T v. Peabody (1994) 181 CLR 359; 94 ATC 4663; (1994) 28 ATR 344, and FC of T v. Spotless Services Ltd & Anor (1996) 186 CLR 404; 96 ATC 5201; (1996) 34 ATR 183.

The arrangements described at paragraphs 4 and 7 above constitute a 'scheme' for the purposes of Part IVA, given the wide definition of 'scheme'.

The 'scheme' includes: • the formation of the special purpose partnership; • the agreements, undertakings, and courses of action and conduct through which the special purpose partnership purports to acquire the licence from the developer and to enter into the commercialisation agreement with the developer; and • the payment made by way of the licence fee, the funding for the payment of the licence fee, the facilitation and servicing of the debt, the minimum income and any other income payments, the put and call option mechanism, and the mechanism whereby the developer or an associate of the developer effectively repays the investors' loans.

The parties to the scheme include the investors in the special purpose partnership, the developer, an associate of the developer, the promoter, the financier, and any guarantor.

A 'tax benefit' is obtained by the investor and the partnership from the scheme. The 'tax benefit' to the investors will be the share of the loss in the partnership. The losses are generated in the partnership solely by its participation in the arrangement. But for the scheme, the deductions would not be available to the partnership and the investors would not have a share in a partnership loss.

Part IVA applies where the investor, or another person or persons, entered into or carried out the scheme, or a part of the scheme, for the sole or dominant purpose of enabling the investor to obtain a tax benefit. This has to be determined having regard to the eight factors referred to in paragraph 177D(b) of the ITAA 1936.

A scheme 'may be ... both "tax driven" and bear the character of a rational commercial decision. The presence of the latter characteristic does not determine the answer to the question of whether, within the meaning of Part IVA, a person entered into or carried out a "scheme" for the "dominant purpose" of enabling a taxpayer to obtain a tax benefit' (refer FCT v. Spotless Services Limited 186 CLR 404 at 415; 96 ATC 5201 at 5206; 34 ATR 183 at 188). A taxpayer's tax saving exceeding its real economic outlay may indicate a sole or dominant purpose of obtaining a tax benefit, notwithstanding that the investment may bear the character of a rational commercial decision.

The promotion of the scheme by others or the existence of a commercial purpose does not preclude the application of Part IVA. Part IVA will apply when the sole or dominant purpose under section 177D is to enable the investors in the partnership to obtain a tax benefit in connection with the scheme.

The relevant person who for the purposes of Part IVA may be judged objectively as having the dominant purpose of enabling the investors in the partnership to obtain a tax benefit may not be the investors or the developer. It may be the person who designed the scheme or some other person who participated in carrying out the scheme or a part of the scheme.

Alternatively, the purpose, or purposes of the investor's professional advisers in recommending the scheme may be attributed to the investor entering into and carrying out the scheme on the basis of their advice (refer FC of T v. Consolidated Press Holdings Limited (No. 1 ) 99 ATC 4945 at 4973; (1999) 42 ATR 575 at 603 per French, Sackville and Sundberg JJ). On appeal this was confirmed by the High Court, particularly where the transactions in question are complex (refer FC of T v. Consolidated Press Holdings Limited & Anor 2001 ATC 4343 at 4360; (2001) 47 ATR 229 at 247 per Gleeson CJ, Gaudron, Gummow, Hayne and Callinan JJ). The investor may be judged objectively as having the dominant purpose of obtaining a tax benefit, albeit by reference to the purpose of the investor's professional adviser.

In paragraph 28 above, arrangements with certain features are identified as arrangements where a reasonable person would conclude that the sole or dominant purpose is to obtain a tax benefit. Each of those features, on its own, may be insufficient to allow a reasonable person to draw the conclusion that the sole or dominant purpose was to obtain a tax benefit. However, a weighing of all these factors against any commercial elements of the arrangements produces that conclusion, particularly as the security deposit is available to repay the investors' loans and the tax saving by the investors in the partnership exceeds their real economic outlay.

In considering the application of section 177D the following propositions as stated in Spotless are relevant: 'A person may enter into or carry out a scheme, within the meaning of Pt IVA, for the dominant purpose of enabling the relevant taxpayer to obtain a tax benefit where that dominant purpose is consistent with the pursuit of commercial gain in the course of carrying on a business' (186 CLR 404 at 415; 96 ATC 5201 at 5206; 34 ATR 183 at 187). 'A particular course of action may be ... both "tax driven" and bear the character of a rational commercial decision. The presence of the latter characteristic does not determine the answer to the question whether, within the meaning of Pt IVA, a person entered into or carried out a "scheme" for the "dominant purpose" of enabling the taxpayer to obtain a "tax benefit"' (186 CLR 404 at 416; 34 ATR 183 at 188). 'Much turns upon the identification, among various purposes, of that which is the "dominant". In its ordinary meaning, dominant indicates that purpose which was the ruling, prevailing, or most influential purpose. In the present case, if the taxpayers took steps which maximised their after-tax return and they did so in a manner indicating the presence of the "dominant purpose" to obtain a "tax benefit", then the criteria which were to be met before the Commissioner might make determinations under section 177F were satisfied' (186 CLR 404 at 416; 96 ATC 5201 at 5206; 34 ATR 183 at 188).

In our view the only party with a relevant commercial purpose under these arrangements is the developer. The investor's only real economic benefit arises through the income tax deductions available to it.

The factors discussed in the following paragraphs indicate that the sole or dominant purpose of an investor participating in these arrangements would be to obtain a tax benefit. On that basis, Part IVA will apply.

The primary result under these arrangements is the transfer of a Division 40 deduction from the developer to the partnership which is distributed to the investors as their share of the partnership loss.

These arrangements involve a blatant transfer of the Division 40 tax benefits available to the developer. The form of the arrangement is such that ownership is purportedly held by the partnership which does not bear the normal risks and benefits of ownership. The substance of the arrangements is that the partnership is not the holder of rights.

The integrated nature of the agreements is such that what the developer transfers is immediately transferred back. As indicated at paragraphs 47 and 48 above, we do not accept that the partnership is dealing at arm's length with the developer and the associate of the developer in relation to these agreements.

In these arrangements the investor is not subject to any financial risk when the tax saving and the put and call options are taken into account. The investors are not subject to any risk because of the guaranteed income, and mechanisms to fund the loan repayment where there is insufficient income under the commercialisation agreement formula to repay the loans.

The investors partly finance the deductible expenditure through borrowings, and guarantees are provided which equal the interest payments and the debt outstanding if there are insufficient profits. That is, to the extent that the deduction sought is in respect of expenditure funded by a loan with the repayment being covered by guarantees, it is in respect of expenditure which is not at risk.

Payment of the minimum income amounts and repayment of the loan principal are guaranteed by security provided by the developer. The value of the 'security 'is sufficient to cover the loan obligations under the facility agreement.

Where the licence fee payment is used to underpin the various guarantees, there is a round robin arrangement within the definition in Taxation Ruling TR 2000/8. In particular, paragraph 27 of TR 2000/8 includes any mechanism employed to effect discharge of liabilities but which does not, in reality, result in an equal enrichment of the creditor either by cash accretion or the gaining of valuable realisable assets.

In these type of arrangements, a 'round robin' exists where: • the investors borrow an amount from the financier; • the amount borrowed is then used, together with the funds the investors have contributed from their own resources to pay the developer for the licence; • the developer places the licence acquisition amount on deposit with the financier to secure the repayment of the borrowing; and • the security deposit, the accrued interest on the deposit and the royalty account are used to extinguish the borrowing under the capitalised debt facility.

The minimum income guarantee and the security deposit are designed to cover the loan obligations. The security deposit and the accrued interest on the deposit will satisfy the investors' loan repayment obligations.

The loan to the investors in the partnership is a limited recourse loan within the definition provided by Taxation Ruling TR 2000/8 at paragraphs 20 - 22.

In these arrangements, a partnership is used and its only assets are the licence and any guarantees it is able to call upon. These arrangements are effectively non-recourse because the lender has no recourse beyond the partnership assets.

The attraction of the scheme to a potential investor is deductions by way of the partnership loss.

The arrangement will only be profitable if the commercialisation program exceeds business plan projections. Viewed objectively, there is only a mere theoretical possibility, rather than a reasonable expectation, of additional royalty income.

Under the scheme, the tax saving from the partnership loss exceeds the investor's cash outlay and the investors profit regardless of how successful the commercialisation program is.

The integrated nature of the agreements means that the parties to the scheme are not dealing at arm's length in relation to the agreements and transactions.

The features of this arrangement which do not appear to involve arm's length dealings include the features identified in paragraphs 47 and 48 above.

The effect of the commercialisation agreement is that the intellectual property is effectively returned to the control of the developer. This is consistent with our view that the partnership never possessed any real rights in relation to the intellectual property.

The features outlined in paragraphs 4 and 7 above are relevant to the manner in which a scheme was entered into or carried out and indicate a lack of commerciality. Additional factors in relation to a specific arrangement will also be relevant.

The scheme involves a number of integrated agreements which include the licence agreement between the developer and the partnership and the commercialisation agreement between the partnership and the developer. The licence agreement and the commercialisation agreement are for the same period. The licence agreement grants an exclusive licence to the partnership.

Under the terms of the licence agreement the developer retains effective possession of the item of intellectual property at all times. In substance there is a cash payment by the investors in the partnership to the developer and tax deductions to the investors in the partnership.

The scheme is entered into after the intellectual property has been created.

Deductions would be available to the investors in the partnership.

The investors' tax savings as a result of the scheme exceed their outlay.

The developer receives funds from the investors.

The investors have little or no upside exposure or downside risk but a significant tax benefit which exceeds the commercial costs.

N/A

Below is a detailed contents list for this Ruling: Paragraph What this Ruling is about 1 Conversion Table - New Law to Old Law 3 Class of person/arrangement 4 Background 9 The operation of Division 40 9 Ruling 13 Holder of the item of intellectual property 13 Cost of the item of intellectual property 15 Disposal of all the rights 16 Adjustable value and termination value on disposal 18 Partial disposal of the rights 19 Recouped expenditure - the application of section 82KL 20 Eligible relevant expenditure 21 Tax avoidance agreement 22 Additional benefit 23 Expected tax saving 25 Commercialisation fees, interest and other fees 27 General anti-avoidance provisions - the application of Part IVA 28 Date of effect 31 Explanations 33 The operation of Division 40 33 Holder of the item of intellectual property 41 Cost of the item of the intellectual property 46 Disposal of all the rights 49 Adjustable value and termination value on disposal 51 Partial disposal of the rights 53 Recouped expenditure - the application of section 82KL 55 Eligible relevant expenditure 56 Tax avoidance agreement 57 Additional benefit 61 Expected tax saving 65 Commercialistaion fees, interest and other fees 70 General anti-avoidance provisions - the application of Part IVA 76 Scheme 77 Tax benefit 80 Purpose 81 The contrived transfer of a tax benefit 90 The immediate disposal of all effective rights, on non-arm's length terms, following its acquisition 92 The lack of any financial risk to an investor, and the manner in which the risk is removed 93 The provision of guarantees to the investors in the partnership 95 The use of the licence fee payment to effectively underpin the various guarantees 96 The matching of guarantees with the liabilities of the investors 98 The effective presence of limited recourse loans 99 The realisation of a commercial return by means of a tax concession 101 The presence of dealings, which are not at arm's length, between the parties 104 The commercialisation agreement 106 Factors in paragraph 177D(b) 107 (i) The manner in which the scheme was entered into or carried out 107 (ii) The form and substance of the scheme 108 (iii) The time at which the scheme was entered into and the length of the period during which the scheme was carried out 110 (iv) The result in relation to the operation of the ITAA 1936 or the ITAA 1997 that, but for Part IVA, would be achieved by the scheme 111 (v) Any change in the financial position of the relevant taxpayer that has resulted, or will result, or may reasonably be expected to result, from the scheme 112 (vi) Any change in the financial position of any person who has, or has had any connection with the relevant taxpayer, being a change that has resulted, or will result, or may reasonably be expected to result, from the scheme 113 (vii) Any other consequence for the relevant taxpayer, or for any person referred to in (vi), of the scheme being entered into or carried out 114 (viii) The nature of any connection between the relevant taxpayer and any person referred to in (vi) 115 Detailed contents list 116 Your Comments 117

You have until 25 January 2002 to make comments on this draft. Please provide comments to: Contact officer details have been removed following publication of the final ruling.