Taxation Problems in the Commercialisation of Intellectual Property · 2015-10-06 · successful, there is no special tax assistance for the intermediate phase of commercialisation

Intellectual Property Research Institute of Australia

Taxation Problems in the Commercialisation of Intellectual Property

Cameron Rider, Lillian Hong,

Ann O’Connell, Miranda Stewart, Michelle Herring.

TAXATION PROBLEMS IN THE COMMERCIALISATON OF

INTELLECTUAL PROPERTY

CAMERON RIDER, LILLIAN HONG, ANN O’CONNELL, MIRANDA STEWART,

MICHELLE HERRING.

THE TAX GROUP MELBOURNE LAW SCHOOL

THE UNIVERSITY OF MELBOURNE

IPRIA Report No. 01/06

©2006 The University of Melbourne, Cameron Rider, Lillian Hong, Ann O’Connell, Miranda Stewart and Michelle Herring. COPYRIGHT: All rights reserved. Apart from fair dealing for the purposes of research or private study, or criticism or review, as permitted under the Copyright Act 1968, no part of this publication may be reproduced stored or transmitted in any form or by any means without the prior permission in writing of the publisher.

ISSN 1449-8804 This issue may be cited as: IPRIA Report No. 01/06. Published by Printed By Intellectual Property Research Institute of Australia Design and Print Centre The University of Melbourne The University of Melbourne Law School Building Melbourne Victoria 3010 Melbourne Victoria 3010 Australia Australia

Table of contents

Chapter 1 Introduction...........................................................................................................................................................................1

Chapter 2 Overview and summary statement of findings..................................................................................................................5 2.1 Central role of IP spin-off companies under tax assistance regime .........................................................................5

2.2 Commercial considerations also indicate spin-off company is preferred commercialisation vehicle .......................7

2.3 Countervailing taxation considerations inhibit use of IP spin-off company as a commercialisation vehicle.............8

2.4 Summary of findings .................................................................................................................................................9

2.5 Reform proposals ...................................................................................................................................................12

Chapter 3 Commercialisation of intellectual property......................................................................................................................15 3.1 Alternative sources of commercialisation revenue .................................................................................................15

3.2 Place of the spin-off company in the different stages of commercialisation of intellectual property ......................16

Chapter 4 General tax regime for intellectual property commercialisation by a spin-off company............................................19 4.1 General rates of taxation ........................................................................................................................................19

4.2 Income/capital distinction and CGT discount concession for capital gains ............................................................19

4.3 Tax treatment of grants and subsidies....................................................................................................................20

4.4 General tax treatment of expenditure on intellectual property................................................................................21 4.4.1 Capital allowances regime........................................................................................................................22 4.4.2 Trade secretes, know-how and confidential information ..........................................................................23 4.4.3 Tax treatment of commercialisation transactions involving intellectual property ......................................24

4.5 Stamp duty..............................................................................................................................................................25 4.5.1 Historical duty position of intellectual property..........................................................................................25 4.5.2 Recent duty reforms on intellectual property ............................................................................................25 4.5.3 Stamp duty and shares .............................................................................................................................26

4.6 Goods and Services Tax ........................................................................................................................................26

4.7 Other labour taxes ..................................................................................................................................................27

Chapter 5 Intellectual property commercialisation and roles of special tax concessions...........................................................29 5.1 Basis of general case for special concessions .......................................................................................................29

5.2 How do tax concessions increase investment in an activity?.................................................................................30

Chapter 6 Special tax concessions relevant to intellectual property in Australia.........................................................................33 6.1 The R&D Concession .............................................................................................................................................33

6.1.1 General operation of R&D concession .....................................................................................................34 6.1.2 In generaly only companies are eligible....................................................................................................34 6.1.3 Different types of expenditure...................................................................................................................35 6.1.4 Definition of ‘R&D activities’ ......................................................................................................................35 6.1.5 “R&D activities” generally do not include commercialisation activity ........................................................35 6.1.6 Other limitations ........................................................................................................................................36 6.1.7 Constraints on commercialisation when R&D concession has been claimed ..........................................36 6.1.8 Tax treatment of commercialisation proceed when R&D concession claimed.........................................37 6.1.9 Additional 175% premium deduction for above average non-plant expenditure ......................................37 6.1.10 R&D tax offset for small companies..........................................................................................................37

6.2 Concessions for PDFs and VCLPs.........................................................................................................................38 6.2.1 PDFs .........................................................................................................................................................38 6.2.2 Venture Capital Limited Partnerships .......................................................................................................40

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6.3 Grant programs.......................................................................................................................................................47

6.4 Relationship of special tax concessions to use of IP spin-off companies ..............................................................47

Chapter 7 Alternative commercialisation vehicles and their general tax treatment .....................................................................49 7.1 Limited liability company.........................................................................................................................................49

7.2 General law partnership..........................................................................................................................................50

7.3 Unincorporated joint venture...................................................................................................................................50

7.4 Unit trust..................................................................................................................................................................51

7.5 Non-taxation considerations favour company over other commercialisation vehicles ...........................................52 7.5.1 Advantages of Company...........................................................................................................................52 7.5.2 General partnership compared to company .............................................................................................53 7.5.3 Unincorporated joint venture compared to general partnership ...............................................................53 7.5.4 Unit trust compared to company...............................................................................................................53 7.5.5 Conclusion ................................................................................................................................................54

7.6 General tax considerations favour unincorporated vehicles over a company ........................................................54 7.6.1 Taxation treatment of company and partnership compared .....................................................................55 7.6.2 Importance of treatment of start-up losses ...............................................................................................56 7.6.3 Advantages of unincorporated joint venture compared to company and partnership ..............................57 7.6.4 Taxation treatment of unit trust compared to company and partnership ..................................................58

Chapter 8 Problems in the contribution of intellectual property assets to a spin-off company..................................................61 8.1 Taxation of future unrealised gains on formation of commercialisation vehicle .....................................................61

8.2 Position if spin-off company used as commercialisation vehicle ............................................................................61

8.3 Rollover concessions limited ..................................................................................................................................62

8.4 Interaction with R&D concession ............................................................................................................................63

8.5 Position if general partnership used as commercialisation vehicle ........................................................................63

8.6 Scrip-for-scrip rollover.............................................................................................................................................64

8.7 Use of “modified” unincorporated joint venture structure........................................................................................64

8.8 Position if unit trust used as commercialisation vehicle..........................................................................................65

8.9 US position compared ............................................................................................................................................65

8.10 Conclusion ..............................................................................................................................................................66

Chapter 9 Does the income tax system discourage employee share ownership in intellectual property spin-off companies?67 9.1 Importance of employee shares to IP spin-off companies......................................................................................67

9.2 Income tax law generally discourages use of employee shares: taxation of unrealised future gains ....................68

9.3 Limited concessions do not assist IP spin-off companies ......................................................................................68

9.4 Division 13A............................................................................................................................................................69 9.4.1 Policy of Division 13A ...............................................................................................................................69 9.4.2 Different types of employee share plans ..................................................................................................70

9.5 Division 13A and the provision of shares or rights .................................................................................................70 9.5.1 Any shares of rights ..................................................................................................................................70 9.5.2 Acquired under an employee share scheme ............................................................................................71 9.5.3 Acquired by an employee or service provider (or an associate)...............................................................71 9.5.4 Calculating the amount to be included in assessable income ..................................................................72 9.5.5 Complex valuations of shares and rights required....................................................................................72

9.6 Qualifying for concessions......................................................................................................................................73 9.6.1 “Qualifying” shares and rights ...................................................................................................................73 9.6.2 Problems faced by IP spin-off company in meeting conditions ................................................................73

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9.6.3 Other problems with concession conditions .............................................................................................74 9.7 The operation of the exemption and deferral concessions.....................................................................................74

9.7.1 The exemption concession .......................................................................................................................74 9.7.2 The deferral concession............................................................................................................................75

9.8 Position of employer ...............................................................................................................................................75

9.9 Other taxing provisions ...........................................................................................................................................76

9.10 Interaction with CGT ...............................................................................................................................................76 9.10.1 CGT discount ............................................................................................................................................77

9.11 The provision of shares or rights accompanied by a low interest loan...................................................................78

9.12 The provision of shares or rights using an employee share trust ...........................................................................78

9.13 Plans that do not qualify for concessions ...............................................................................................................80

9.14 Plans that fall outside Division 13A.........................................................................................................................80 9.14.1 Offering shares or rights at full market value ............................................................................................80 9.14.2 Schemes that offer interests that are not shares or rights........................................................................81

9.15 Partnership compared ............................................................................................................................................82

9.16 Conclusions – current law unsatisfactory ...............................................................................................................82

Chapter 10 Problems with start-up losses in use of spin-off companies for commercialisation of intellectual property..........85 10.1 General economic analysis of risk and treatment of start-up losses ......................................................................85

10.2 Problems with use of IP spin-off company .............................................................................................................86

10.3 Position of partnership compared ...........................................................................................................................87

10.4 Unincorporated joint venture compared..................................................................................................................87

10.5 Problems in relation to R&D concession ................................................................................................................87

10.6 Problems with distributions of profits which recoup losses.....................................................................................88

10.7 Conclusion – reform needed...................................................................................................................................88

Chapter 11 Problems in use of spin-off company for distribution of commercialisation income and realisation of capital gains.....................................................................................................................................................................................89 11.1 Problems For Tax-Exempt Institutions In Use Of Spin-Off Company ....................................................................89

11.2 Claw-back of losses on distributions of income by spin-off company ....................................................................89

11.3 Partnership compared ............................................................................................................................................90

11.4 Unincorporated joint venture...................................................................................................................................90

11.5 Capital gains tax concessions – spin-off company offers superior outcomes ........................................................90

11.6 Can a partnership convert to a company to attract CGT concessions? .................................................................91

11.7 Can a unit trust attract CGT concessions?.............................................................................................................91

11.8 Can a unit trust offer tax exempt income to tax exempt investors?........................................................................91

11.9 Conclusions ............................................................................................................................................................92

Chapter 12 Problems in tax treatment of commercialisation expenses of intellectual property spin-off company....................93 12.1 Current position under Australian law.....................................................................................................................93

12.1.1 Problems with capital allowances regime .................................................................................................93 12.1.2 Proposed reforms of capital allowances regime.......................................................................................95 12.1.3 Australian tax law may encourage offshore transfer of intellectual property ............................................96

12.2 Tax treatment of intellectual property commercialisation expenditure in US and UK.............................................96

12.3 Conclusions ............................................................................................................................................................97

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Chapter 13 Problems in unwinding an intellectual property spin-off company structure .............................................................99 13.1 Potential exit scenarios...........................................................................................................................................99

13.2 Spin-off company leads to taxation costs on exit or unwind...................................................................................99

13.3 Spin-off company has advantages on partial sell-down or mergers.....................................................................100

13.4 Partnership compared ..........................................................................................................................................100

13.5 Conclusions ..........................................................................................................................................................101

Chapter 14 Concluding remarks .........................................................................................................................................................103

Appendices .................................................................................................................................................................................................. 107

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Chapter 1 Introduction

A curious feature of the Australian tax treatment of intellectual property is that, while specific tax incentives are given to initial research and development activity which might generate intellectual property with commercial potential, and while significant tax concessions are given to capital gains which might be realised if a project for commercialisation of intellectual property is ultimately successful, there is no special tax assistance for the intermediate phase of commercialisation activity itself – the activity by which the knowledge, ideas and inventions generated by the research and development are converted into the business assets capable of producing commercial revenues from marketable goods and services.

Figure 1: Structure of tax assistance for intellectual property commercialisation

RESEARCHAND

DEVELOPMENTCOMMERCIALISATION

ACTIVITYCAPITAL

GAINS

TAX INCENTIVES

TAX CONCESSIONS

This feature is curious, because the rationale for offering the tax incentives to the research and development, and for allowing the tax concessions to the capital gains, is a rationale which has equal application to commercialisation activity itself. The case for the tax assistance rests on the proposition that entrepreneurial activity associated with commercial and development of intellectual property is subject to unusually high levels of business and financial risk1. As a result of the high risk levels, in the absence of tax concessions, private firms will tend to allocate less than socially optimal levels of investment of labour and capital to intellectual property development2. The income tax system can be used to offset the effect of the higher risk on investment decisions by offering increased returns on such investment by way of lower rates of taxation in relation to intellectual property development than would apply in relation to other business activity considered to have lower risk (such as passive investment in shares and real estate)3. Increased returns on intellectual property commercialisation, due to lower tax rates, might also encourage individuals to forsake less risky occupations as wage and 1 As stated by Christian Keuschnigg, “Public Policy and Venture Capital Backed Innovation” (October 2003) CESifo

Working Paper No 1066, “innovative young firms have high potential but are very risky as well. Developing a business idea into a new marketable product involves formidable technological and managerial risks” (p1).

2 See Guellec and van Pottelsberghe, “Does Government Support Stimulate Private R&D” in OECD Economic Studies No.29 1997/II, p.95.

3 See a discussion of the arguments for and against this view in OECD Directorate for Science, Technology and Industry, Entrepreneurship and Growth: Tax Issues (February 2002).

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salary employees, for higher risk self-employed entrepreneurial activity in industries associated with intellectual property.4

This being so, it appears somewhat surprising that tax assistance is withheld from the actual commercialisation activity itself, and instead offered only in the initial phases of research and development, and the final phases of a successfully realised commercialisation project. It seems plausible to suggest that the high levels of risk associated with the commercialisation activity itself could still lead to less than socially optimal levels of intellectual property development, and that a case for tax assistance at this phase of development could also be made out. Nonetheless, the policy structure appears to rest on the critical assumption that the initial support to research and development, together with the incentive of lower rates of taxation of capital gains in the event of ultimate success, should provide a sufficient offset to the high levels of risk associated with commercialisation to ensure adequate investment in intellectual property by private firms.

This critical assumption presupposes, of course, that the taxation treatment of the commercialisation activity itself does not present any special obstacles or disincentives to commercialisation which are likely to discourage investment in intellectual property, and thus reverse, or at least dilute, the intended policy effect of the incentives for research and development and the concessions for capital gains. It is the purpose of this Working Paper to investigate whether the supposition that there are no special obstacles or disincentives is indeed correct.

The Working Paper undertakes a comprehensive review of the features of the Australian income tax system which inhibit or discourage commercialisation of intellectual property. We find that the income tax law reveals a sub-optimal tendency to impose taxation of unrealised gains, and double taxation of realised gains, from intellectual property commercialisation. Areas we have identified as causing problems include:

(a) up-front tax liabilities imposed on the initial contribution of intellectual property to commercialisation vehicles such as spin-off companies;

(b) inappropriate tax liabilities imposed on employee shares in start-up companies;

(c) unfavourable tax treatment of start-up losses where the commercialisation vehicle is a limited liability company;

(d) denial of tax deductions for many intellectual property commercialisation cost items, such as confidential information, trade secrets, trade marks, brands and goodwill;

(e) features of the general tax law which negate the intended benefits of specific concessions such as deductions for research and development and the venture capital and pooled development fund concessions;

4 See OECD Directorate for Science, Technology and Industry, Entrepreneurship and Growth: Tax Issues (February

2002); William M Gentry and R Glenn Hubbard, ‘“Success Taxes”, Entrepreneurial Entry and Innovation’ (June 2004) National Bureau of Economic Research Working Paper 10551; Robert Carroll, Douglas Holtz-Eakin, Mark Rider and Harvey S Rosen, “Entrepreneurs, Income Taxes and Investment” (1998) NBER Working Paper 6374.

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Introduction

(f) tendencies in the tax law to encourage relocation of intellectual property ownership and control to more favourable overseas jurisdictions; and

(g) tendencies in the tax law to discourage investment in entrepreneurial risk activity as an alternative to passive low-risk investment activity.

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Chapter 2 Overview and summary statement of findings

In this Working Paper we consider the operation of the tax system where owners of intellectual property generated by research and development decide to form a separate limited liability company for the purpose of commercialising the intellectual property – ie developing the intellectual property to the point where it is a business asset capable of use in the production of marketable goods and services.

In analysing the taxation treatment of intellectual property commercialisation, it is important to understand how the tax assistance regime for intellectual property effectively mandates the use of companies as the enterprise vehicle for the commercial development of intellectual property assets. Such companies are commonly referred to as “intellectual property spin off companies”.

2.1 Central role of IP spin-off companies under tax assistance regime

The first fundamental element of the tax assistance regime relevant to intellectual property is the provision of special tax incentives for research and development activity (the R&D concessions). The R&D concessions take the form of concessional tax deductions for expenditure on eligible research and development activities (the R&D activities). The primary concession is to allow a deduction equal to 125% of the relevant expenditure. In some cases, a deduction equal to 175% of expenditure may arise. Smaller enterprises may also be able to convert the tax deduction (which is applied to reduce tax on other income) into a tax rebate (which is taken as a cash payment). To qualify for the R&D concession, however, the relevant R&D activities must ordinarily be undertaken by a company – that is, a company incorporated under the laws of Australia5. Hence, the R&D concession not only presupposes, but in fact establishes as a mandatory condition of the tax assistance, that the intellectual property the subject of the research and development (R&D) will be developed by a corporate vehicle.

The second fundamental element of the tax assistance regime relevant to intellectual property development is the provision of concessional tax rates for capital gains. The primary concession is the “CGT discount” for individuals. It provides that only one half of any capital gain on a disposal of a relevant asset should be subject to capital gains tax, provided the asset is held for at least 12 months before disposal.6 To qualify for the CGT discount, however, the asset in question must be a recognised “CGT asset” – that is, an asset whose gains are treated for income tax purposes as “capital” gains rather than as “revenue” or “income” gains. A share in a spin-off company, if held as an investment, will qualify as a “CGT asset”.

In this respect, it is noteworthy that it will be a rare case where intellectual property assets themselves will qualify as CGT assets. In particular, a patent, registered design or copyright is expressly deemed not to be a CGT asset, but rather a “depreciating asset”, whose gains are of a revenue nature.7 Moreover, intellectual property in the form of know-how, trade secrets or confidential information is also unlikely to be treated as a CGT asset.8 In addition, in the case of the disposal of intellectual

5 See section 73B of Income Tax Assessment Act 1936 (ITAA 1936) and definition of “eligible company”. 6 See Division 115 of Income Tax Assessment Act 1997 (ITAA 1997). 7 Section 40-30(2)(c)and section 40-285 of ITAA 1997. 8 See Taxation Ruling TR 98/3.

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property created by expenditure for which the R&D concession has been claimed, the gains are deemed to be of a revenue rather than capital nature.9

On the other hand, gains on the disposal of shares held in a company, where the shares are held as an investment, will generally qualify as capital gains eligible for the CGT discount. This will be so, even where the company holds intellectual property assets, and conducts R&D, not eligible for capital gains tax treatment. Hence, to qualify for the CGT discount, individuals involved in intellectual property commercialisation will generally need to locate the intellectual property assets, and commercialisation activity, in a special purpose company, ie an “IP spin-off company”, with a view to realising capital gains in respect of the enterprise by disposal of shares in the company, rather than disposal of the actual intellectual property assets themselves.

Thus, the CGT discount tends to reinforce the R&D concession, in dictating the use of an IP spin-off company as the relevant commercialisation vehicle.

This tendency is further reinforced by two other forms of tax concession relevant to intellectual property commercialisation, namely those made available to Pooled Development Funds (PDF’s) and Venture Capital Limited Partnerships (VCLP’s). As discussed in more detail later in this paper, PDF’s and VCLP’s, and investors in PDF’s and VCLP’s, are eligible for various tax exemptions and concessions on their investments. The exemptions and concessions are designed to attract investment capital to the PDFs and VCLPs so that they can in turn invest “patient” equity capital in small and medium enterprises. These concessions are relevant to, but not limited to, intellectual property. However, to qualify for these concessions and exemptions, the PDF’s or VCLP’s must be investing the patient equity in companies. It is not permitted that they hold investments in non-corporate vehicles. Hence, any intellectual property commercialisation enterprise, which wishes to access patient equity capital under the PDF or VCLP regimes, will need to organise itself as a corporate vehicle, ie as an “IP spin-off company”.

In summary, the tax assistance regime presupposes that the benefits of tax assistance for intellectual property will be accessed by use of companies. The originators of intellectual property, and the “knowledge workers” responsible for the research and development, commercialisation, and investors of capital, will contribute the intellectual property assets and the associated labour and capital, to a company. The company will be assisted by R&D concessions. The owners will be encouraged by tax concessions for capital gains on the sale of their shares in the company in the event of successful commercialisation.

Hence, the central role of IP spin-off companies as the relevant vehicle for intellectual property commercialisation. Figure 2 presents this in diagrammatic form.

9 See section 73B(27A) of ITAA 1936.

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Overview and summary of findings

Figure 2: Role of spin-off company in intellectual property tax assistance regime

INDIVIDUALS• IP originators• Knowledge-

workers• Investors

IP SPIN-OFF COMPANY• Owns IP• Conducts R&D• Generates

commercialisation revenues

SHARESTax conce(CGT discconcession

ssions on shares ount; venture capital s, PDF concessions)

Corporate tax incentives for R&D (R&D concessions)

Contribute IP, labour, capital

2.2 Commercial considerations also indicate spin-off company is preferred commercialisation vehicle

Commercial considerations also indicate that the preferred vehicle for most forms of business enterprise would be the limited liability corporation. A limited liability corporation formed to commercialise intellectual property, as noted above, is commonly referred to as an ‘IP spin-off company’. The term is descriptive of commercialisation activity which has its origins in research and development activity conducted by individuals, companies or institutions. Knowledge, ideas and inventions which are generated by the research and development, and identified as having the potential to be converted into sources of commercial revenue, are transferred into a special purpose company for the purpose of developing the intellectual property to the point where it can be used in the production of marketable goods and services.

The transfer of the intellectual property to an IP spin-off company offers numerous business and commercial advantages. It enables the original proprietors of the intellectual property to undertake the commercialisation activity without being exposed to direct legal liability for the activity. The corporate form confers the protection of limited liability.

An IP spin-off company also enables the original proprietors to raise the equity and debt capital needed to fund the commercialisation activity. The equity and debt can be raised against the intellectual property assets to be commercialised, rather than the general assets of the proprietors. The providers of equity and debt capital can be given a direct economic interest in both the intellectual property and the associated product of the commercialisation activity.

Use of the corporate form by the IP originators also facilitates the disposal of part or all of their interest in the enterprise by the sale of their shares. This is easier than disposal of direct interests in the intellectual property assets themselves. In addition, use of the company form facilitates the engagement of employees on terms that a substantial part of their remuneration should consist of shares or options in the enterprise rather than money salary. This is an important consideration where

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the commercialisation activity will initially generate no independent cash-flow, and will depend heavily on the skills and motivations of the contributors of its intellectual labour.

Thus, all other things being equal, commercial efficiency suggests that a special purpose limited liability corporation – a spin-off company – should be the preferred vehicle for an intellectual property commercialisation enterprise. Commercial considerations, together with the design of the R&D concession, and the tax concessions for capital gains on share investments in companies, all point towards adoption of an IP spin-off company as the preferred form of legal entity for intellectual property commercialisation.

2.3 Countervailing taxation considerations inhibit use of IP spin-off company as a commercialisation vehicle

The design of the tax assistance regime relevant to intellectual property presupposes that an IP spin-off company can be, and will be, adopted as the vehicle by which access to the tax assistance is obtained. Indeed, if a corporate vehicle is not adopted, the operation of the assistance regime is frustrated. This has certain important implications.

In particular, it would suggest that ease of adoption of the spin-off company form as a commercialisation vehicle is critical to the efficiency of the tax assistance regime in delivering its intended policy outcomes. To recap, the tax assistance regime has the object of offsetting the disincentives to private investment in intellectual property which arise from the high levels of commercial risk associated with intellectual property development, and the assistance regime, if it operates as it is intended, does this by the provision of tax incentives and concessions which increase the effective rate of return on intellectual property investment by companies and their shareholders. It follows that, if there are countervailing tax considerations which inhibit adoption of the spin-off company form as a commercialisation vehicle, then the efficiency of the tax assistance regime in delivering its policy objectives will be seriously impaired. In such a case, removal of those countervailing tax considerations may well be a proper subject of tax reform.

The question, therefore, is whether the use of an IP spin-off company may be inhibited by countervailing tax considerations. In principle, countervailing tax considerations may arise at various points. For example, where the intellectual property needs to be transferred from current owners to the spin-off company, the taxation costs associated with the initial transfer of intellectual property to the spin-off company may be so high as to render the proposed transfer uneconomic.

In addition, if the general tax law offers more favourable treatment to an alternative commercialisation vehicle - such as an unincorporated joint venture, a partnership or a trust –the tax advantages of the alternative form may outweigh the commercial advantages, and the tax assistance, associated with use of a spin-off company. This may occur, for example, if the alternative form will offer to investors in the enterprise a more favourable taxation treatment of the start-up losses and other expenditures associated with the commercialisation activity, or if it provides a more tax-effective outcome for tax-exempt or foreign investors. In such a case, the parties may elect to adapt the alternative form of vehicle and forgo the tax assistance designed for the spin-off company.

Finally, countervailing tax considerations may operate to restrict or inhibit other commercial advantages which would arise from locating the commercialisation activity in the spin-off company. For example, one clear advantage of the IP spin-off company over alternative forms of vehicle is that the spin-off company allows the use of employee shares and options in lieu of many salaries to reward employees. This advantage may be negated, however, if the company cannot adopt extensive use of

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employee shares and options in lieu of money salaries, due to the unfavourable taxation treatment of such arrangements. Unfavourable treatment of employee shares will thus inhibit IP spin-off companies.

To investigate these matters, we have examined in this Working Paper the operation of Australian tax laws on both the transfer of intellectual property to a spin-off company, and the subsequent use of third party equity and debt capital, and employee shares and options, to conduct commercialisation activity. Our examination proceeds from a simple case of an IP spin-off company being formed by the original proprietors of intellectual property generated by research and development activity, with the intention that the company should undertake the commercialisation activity, that it should raise working capital by issuing equity to a group of investors, and that it should attract and reward employees by offering shares and options in the company. We examine the tax costs and disincentives which arise in adopting this structure. We also compare the position under certain alternative structures.

2.4 Summary of findings

Our conclusion is that, under current tax law, use of an IP spin-off company creates various countervailing taxation problems which effectively undermine the efficiency of the tax assistance regime in achieving its intended policy outcomes. Our principal findings include, in summary, the following:

(a) Formation of a spin-off company can be discouraged due to taxation costs suffered by the original proprietors of the intellectual property on the contribution of the intellectual property assets to the spin-off company. The tax law, in general, treats the contribution of intellectual property assets to a company in exchange for shares, as a taxable sale of the intellectual property assets for a taxable consideration equal to their market value at the time of contribution (see Figure 3). Subject to limited exceptions, this means the IP originators are taxable on the present market value of the intellectual property assets, which will equate to the present value of potential future net cash-flows generated by the assets. This represents, in effect taxation of unrealised gains – it is taxation of the present value of future, and uncertain, income flows which might be generated from the intellectual property if, and only if, the commercialisation activity is successful.

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Figure 3: Contribution of intellectual property to spin-off company in exchange for shares

IP ORIGINATORS

CONTRIBUTE IP Ta

IP SPIN-OFF COMPANY

xable disposal of IP

Deemed to receive taxable consideration equal to

market value of IP

ISSUE SHARES

(b) Use of employee shares and options by IP spin-off companies in lieu of money salary to attract and reward employees can be discouraged due to the unfavourable taxation treatment of such forms of reward. The tax law, in general, treats the receipt of a share or option in lieu of salary, as the receipt of money income equal to the value of the share, and the reinvestment of that money income in the company (see Figure 4). Subject to limited exceptions this means employees are taxable at ordinary income tax rates on the market value of the shares or options. This represents a further case of taxation of unrealised gains – i.e. taxation of the present value of future, and uncertain, capital gains which might be realised in respect of the shares if, and only if, the underlying commercialisation activity of the company is successful.

Figure 4: Issue of employee shares by IP spin-off company in lieu of salary

EMPLOYEES

IP SPIN-OFF COMPANY

CONTRIBUTE LABOUR

Deemed to receive taxable remuneration equal to market

value of shares/options

ISSUE SHARES /OPTIONS

(c) Alternative forms of commercialisation vehicle - such as a partnership or an unincorporated joint venture – can offer countervailing tax advantages under the general tax law which outweigh the

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commercial advantages and tax assistance regime available to a spin-off company. These countervailing advantages take various forms, but have their origin in the fact that such vehicles are, unlike a company, “fiscally transparent”. That is, the tax law generally “looks through” such alternative forms of vehicle to their ultimate owners in taxing the income and allowing deductions for losses in their operations. This has certain favourable outcomes. The contribution of intellectual property assets to such alternative structures may attract lower taxation costs. More importantly, the alternative structures may also attract a more favourable taxation treatment of the start-up losses and other expenditures associated with the initial phases of the commercialisation activity, because the “fiscal transparency” allows the losses to flow through to the owner for them to deduct against other income of the owner. By contrast, in the case of a company, there is no fiscal transparency and the losses are trapped in the company and cannot be used until the company generates income (see Figure 5). Tax exempt institutions may also find such structures preferable to a spin-off company when income is generated, because their fiscal transparency means the income passes through to them as tax exempt. In a company, it is taxed at 30% regardless of the tax exempt status of the owners (see Figure 6). However, these alternative forms of vehicle cannot access the R&D concession; and may not so easily attract the CGT concessions.

Figure 5: Comparison of spin-off company to fiscally transparent partnership* in treatment of start-up losses

SPIN-OFF COMPANY

PARTNERS

PARTNERSHIP *

Start-up losses remain trapped in company for

tax purposes

Start-up losses pass through to partners for

tax purposes

Partners can deduct losses against other income

SHAREHOLDERS

* Same treatment applies to unincorporated joint venture

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Figure 6: Comparison of spin-off company to fiscally transparent partnership* in treatment of income for tax-exempt institutions

OTHER

SPIN-OFF COMPANY

Income taxed at 30%in company for tax purposes

PARTNERSHIP *

Income remains

tax-exempt

TAX-EXEMPT OTHER PARTNERS

Income passes through partnership for tax purposes

TAX-EXEMPT PARTNERSHAREHOLDERS SHAREHOLDER

* Same treatment applies to unincorporated joint venture

In summary, in many cases the preferred structure from a taxation perspective appears to be an unincorporated joint venture or general law partnership, rather than a spin-off company, at least in the case of intellectual property commercialisation activity commenced in circumstances where there is likely to be a period of substantial start-up losses before significant commercialisation revenues are generated. Given neither a joint venture nor a partnership is the optimal vehicle from a commercial or business perspective, and given neither is eligible for the R&D concession, this means the taxation system is creating obstacles to the efficient commercialisation of intellectual property.

2.5 Reform proposals

The Working Paper identifies a series of tax disincentives to the use of IP spin-off companies to commercialise intellectual property. Consequently, we also conclude that there may be a case for a reform of the taxation law to remove these taxation obstacles. While more work is required, our tentative conclusion is that three reforms are worthy of serious consideration:

(a) One reform would be to amend the income tax law so that the original proprietors of intellectual property can contribute the intellectual property to a spin-off company, in exchange for shares, without being subject to taxation costs on the contribution. The reform could take the form of a general “rollover relief” available for the exchange of assets for shares in a company on formation of a business enterprise – no tax paid on unrealised gains at the time of the contribution of assets to the company, but tax payable on the gains if and when they are realised by a subsequent sale of the shares. Such a relief is available under the income tax laws of the United States, where formation of IP spin-off companies is seen to be facilitated by more flexible tax laws.

(b) A second reform would be to amend the income tax law to allow parties to adopt the legal form of a limited liability company for the commercialisation enterprise, but elect the same

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“fiscally transparent” income tax treatment as applies to a general partnership. This would allow start-up losses to flow through to the proprietors of the enterprise for tax purposes. Such elections apply under the income tax laws of the United States, and this flexibility in the United States income tax law is seen to have been an important factor in the growth of commercialisation of intellectual property in that country.

(c) A third area for potential reform concerns shares and options issued to employees in exchange for the investment of intellectual labour in the company. The income tax law could be amended so that such shares and options issued by IP spin-off companies are not taxed as the equivalent of money salary, but rather given the same capital gains taxation treatment as other investments of equity capital at risk in the enterprise. Under capital gains tax treatment, no tax would be paid on unrealised gains at the time the shares are issued, and any gains realised on a subsequent disposal would qualify for the CGT discount. This would enable IP spin-off companies to make use of this important form of employee reward, and give employees parity of tax treatment with other investors in the company. Again, the growth of IP spin-off companies in the United States is thought to have been given significant impetus by the relatively favourable treatment of the employee shares and options under US tax law.

Considerable additional work is required to evaluate these reform options, including further investigation of the operation of the US tax law provisions.10 However, by way of a preliminary contribution to this work, this Working Paper contains, in Appendix B and Appendix C, a review of relevant US tax law provisions prepared by Lillian Hong.11

10 For a critique of US tax treatment of intellectual property, see Mundstock, Taxation of Business Intangible Capital;

(1987) 135 University of Pennsylvania Law Review 1179. 11 Lillian Hong has been the principal research assistant in relation to this report.

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Chapter 3 Commercialisation of intellectual property

The use of an “IP spin-off company” to commercialise IP needs to be analysed in the broader context of commercialisation activity. This Chapter looks at the broader context.

“Commercialisation of IP” is a term which generally describes the activities by which knowledge, ideas and inventions generated by research and development are converted into sources of commercial revenue.12

This Working Paper focuses primarily on the commercialisation of intellectual property that is the product of scientific or innovative research and development by individuals and institutions,13 and that is protected by the laws relating to copyrights, patents, designs, plant breeders rights, circuit layouts, trade secrets and confidential information. Trade marks, brands and other intellectual property relating to the marketing and distribution of goods and services will also be relevant to commercialisation activity (and will often be derived from or related to the former kind of intellectual property). Various tax issues arise with respect to the latter forms of intellectual property, including the ability to write off the cost of that intellectual property and its recognition as an asset for depreciation or capital gains tax purposes. These are discussed briefly, but are not the focus of this Working Paper.

3.1 Alternative sources of commercialisation revenue

The potential sources of commercialisation revenues for intellectual property generated by research and development are diverse. They include:

(a) the use of intellectual property in the provision of services for reward to third parties, such as contract research and development work;

(b) the use of intellectual property in collaborative research projects, such as the federal government’s Co-operative Research Centre program;

(c) the licensing of intellectual property to third parties in exchange for royalties or like payments;

(d) the sale of intellectual property to third parties in exchange for up-front payments, on-going royalties or combinations of both; and

(e) the creation of new business enterprises for the purpose of developing the intellectual property for use in the production of marketable goods and services.14

12 Allens Consulting Group, Building Effective Systems for the Commercialisation of University Research. (August

2004), Report for the Business Council of Australia & Australian Vice-Chancellors Committee (hereinafter Commercialisation of University Research). See p.viii: “Commercialisation of research outcomes is the conversion of knowledge and inventions into products and services for the market”.

13 Such as universities and public research institutions and those who work for such bodies. 14 For example, see Commercialisation of University Research, ibid p.8: “Universities generate revenue from research

activities in a number of ways, including contract research, participation in collaborative research projects that have commercial applications, the creation of spin-off companies and the licensing of intellectual property to existing companies”.

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Chapter 3

Alternatives (a) to (d) may appear to be easier and faster ways to realise commercialisation gains in short term. However, there is evidence that returns to licensing or sale of intellectual property are rarely substantial.15 The last-mentioned form of commercialisation activity – the creation of new business enterprises - is considered to provide the greatest long-term return. It will maximise incentives to IP originators and thus will effectively encourage innovation. Therefore, it seems to us appropriate that it should be the creation of new business enterprises to commercialise intellectual property with which this Working Paper is primarily concerned16.

3.2 Place of the spin-off company in the different stages of commercialisation of intellectual property17

It may be useful to outline the typical stages of intellectual property commercialisation through creation of a new enterprise before moving to the impact of taxation on that process. We adopt here, as a rough analogy to the stages of intellectual property commercialisation, the typical stages of venture capital investment. Venture capital has been the subject of considerable research and public policy experimentation in recent years.18

Venture capital is one form of private equity investing, usually an investment by institutions (such as pension funds or banks), or wealthy individuals, in commercialisation of new ideas, technology or assets in an active enterprise.19 Intellectual property commercialisation may take place through a variety of methods and not simply through this kind of venture capital investment, but the framework is nonetheless informative.

The Australian Bureau of Statistics, and commentators, generally propose three early stages of venture capital investment, being seed, start-up and expansion investing.20 Venture capital investing may then (if successful) end with a buyout or float (IPO). Intellectual property commercialisation may proceed in that manner, or may generate an ongoing, successful business enterprise. Using this framework, we set out the following stages of intellectual property commercialisation. 15 Innovation Summit Implementation Group, Innovation Unlocking the Future (Final Report), Minister for Industry,

Science and Resource & Business Council of Australia (August 2002) (hereinafter Unlocking the Future), p.25. Tax issues associated with licensing or selling intellectual property are discussed in Marua Lui and James Macky, “Commercialising Intellectual Property – A taxing initiative?” (2002) 6(1) The Tax Specialist 10; Geoff Mann, “Expenditure on the development and acquisition of intellectual property” Taxation Institute of Australia Paper, presented 18 June, 2002, Brisbane. As well as producing a lower return, licensing and selling intellectual property in Australia may also attract additional tax costs, such as state duties, as discussed in Mann, pp.12-16.

16 Note, contra, a suggestion that the sale of patents by corporate inventors may actually enhance efficiency, by ensuring that the patents are then developed by the most efficient operator; and further, that US tax law discourages this sale of patents: William A Drennan, “Changing Invention Economics by Encouraging corporate Inventors to Sell Patents” (2004) 58 University of Miami Law Review 1045. However, in any event, this is not likely to apply to the Australian context, where the likely sale is offshore, rather than domestically in Australia.

17 This section was prepared primarily by Miranda Stewart. 18 See, eg, Paul A Gompers and Josh Lerner, The Venture Capital Cycle (1999, 2000) MIT Press; Leslie A. Jeng and

Philipp C Wells, “The determinants of venture capital funding: evidence across countries” (2000) Journal of Corporate Finance 241. There are obvious links between tax considerations with respect to intellectual property commercialisation and tax considerations for venture capital investment more generally, although there may also be some special issues for intellectual property commercialisation.

19 Jeng and Wells, ibid p.243. 20 Australian Bureau of Statistics, Venture Capital 2003-04, Note 5678.0, Explanatory Notes 11 and 12, p.20; Jeng and

Wells, ibid p.243. The early stages of investment through small and medium enterprises commercialising recently developed technology or research has also been labelled investment in “sunrise enterprises”: House of Representatives Standing Committee on Employment, Education and Workplace Relations Report, Shared Endeavours – An inquiry into employee share ownership in Australia ( September 2000). See also Christian Keuschnigg, “Public Policy and Venture Capital Backed Innovation” (October 2003) CESifo Working Paper No 1066.

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Commercialisation of intellectual property

(a) Research and development to generate intellectual property: This may be funded by government directly or in private enterprise, within an institution such as a University, or within an existing business enterprise funded privately. Research and development may take place throughout the lifecycle of a business venture and not simply before its commencement.

(b) Seed capital: Jeng and Wells define this as funds “typically used to fund initial product research and development and to assess the commercial potential of ideas”.21 This is a high risk stage of capitalisation. As noted by Jeng and Wells, enterprises at this stage use more cash than they generate. The ABS suggests that the product is in development at this stage, and the enterprise has usually been in business less than 18 months. Finance, management and other skills may be provided by the IP originators themselves, or by “business angels” - independent business people who can see potential in the business.22

(c) Start-up capital: This is capital which is “targeted at companies that have moved past the idea stage and are gearing up to produce, market, and sell their products”.23 This is still high risk and enterprises at this stage are still using more cash than they generate even if income may begin to be produced. The product may be in pilot production; the business has usually existed for less than 30 months. Venture capitalists may provide financial resources and specialist management and business skills.24

(d) Expansion capital: This is capital for a company “that has already established its product in the market place” but that needs additional capital to “fund the growth of its manufacturing and distribution capacity, as well as to fund further R&D”25 (which takes us back to stage (a)). Clearly, expansion capital is lower risk.

(e) Ongoing operation, buy-out or IPO: a mature stage of capitalisation.

In Australia, much intellectual property is the product of research and development by individuals and institutions lacking the financial and business resources to convert the intellectual property from an asset with commercial potential into a viable commercial asset generating sustainable revenues.26 To obtain access to the necessary financial and business resources, the IP originators will commonly need to enter into some form of economic partnership with other parties such as venture capitalists, multinational enterprises or public research institutions to commercialise their intellectual property. This corresponds with the seed and start-up capital stages of commercialisation identified above.

The most straightforward method of obtaining seed or start-up capital in an economic partnership is to form a jointly owned limited liability company for the purpose of combining the intellectual property and the research expertise of the IP originators with the financial resources and business skills of the venture capitalist or multinational enterprise. Thus, an important form of intellectual property commercialisation activity is the formation of new companies – as noted, often referred to as ‘spin-off companies’27- to commercialise intellectual property.

21 Jeng and Wells, ibid p.243. 22 ABS, above n. 23 Jeng and Wells, ibid p.243. 24 ABS, above n. 25 Jeng and Wells, ibid p.243. 26 Unlocking the Future, ibid p.xi. 27 Commercialisation of University Research, ibid p.8; Australian Institute for Commercialisation, The economic

impact of the commercialisation of publicly funded R&D in Australia (4 September 2003), p.7.

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In Australia, however, it seems that formation of companies as the relevant commercialisation vehicle is less common than might be expected. Most venture capital investment vehicles are either trusts (funds) or corporations that are not tax-exempt entities.28 Many of the funds are in government-linked programs and would operate as investment vehicles through which there is investment in the shares of spin-off companies, rather than directly as spin-off entities themselves. According to the National Survey of Research Commercialisation Years 2001 and 2002, the number of spin-off companies (referred to as “start-up companies” in the survey) formed in Australia is much lower than the number of spin-off companies formed in Canada or the United Kingdom.29 OECD data indicates that the amount invested in Australia in the early stages of the venture capital market is small compared to international levels (based on 1999 data), and that investment at the early stage in the US is 100 times that in Australia.30

28 At the end of June 2004, 43% of venture capital investment vehicles were trusts that invested 58.47% of total capital

and 52.3% were corporations that invested 39.45% of total capital: ABS, 2003-2004 Venture Capital, ibid. 29 Department of Education, Science and Training, National Survey of Research Commercialisation Years 2001 and

2002 (Oct 2004), pp.34-36. That Survey indicates that Australia does form slightly more start-up companies than the United States. It is not clear why this is the case. It might be because the percentage of survey respondents from the United States is relatively low in terms of the total number of universities and publicly-funded research agencies in the United States, or because the spin-off company form is not the dominant form for commercialisation of intellectual property in the US.

30 Unlocking the Future, ibid p.22 and Figure 3.

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Chapter 4 General tax regime for intellectual property commercialisation by a spin-off company

The taxation issues associated with commercialisation of intellectual property need to be analysed in the broader context of the general operation of Australian tax law on commercial activity. This Chapter looks at the general tax regime.

4.1 General rates of taxation

In Australia, income tax is imposed by the Commonwealth government on individuals and on limited liability business enterprises such as spin-off companies.31

The rate of company tax is a flat rate of tax of 30%. The rate for an individual increases as income rises, with a top marginal rate of 48.5%.

Tax laws distinguish between “resident” and “non-resident” entities. A company formed under Australian company law will be treated as a resident company for income tax purposes, subject to tax on its world-wide income, profits and gains32. An individual living and working in Australia for any lengthy period will also be treated, in most cases, as a resident subject to tax on world-wide income, profits and gains. Non-resident companies and individuals are generally subject to tax only on profits and gains derived from Australian sources.

Items subject to income tax include the income, profits and capital gains of commercial activities. Thus the income tax will ordinarily apply to the profits of a spin-off company formed to commercialise intellectual property in Australia. It will also be imposed on the wages, salary and other remuneration of those individuals who perform work or services for the spin-off company in Australia. It will also apply to gains on the sale of shares in a spin-off company.

Should the spin-off company distribute its profits by way of dividend to its shareholders, the dividends will ordinarily be subject to income tax in the hands of the shareholders in Australia; however, if the profits have borne company tax, a credit will be given for that tax under the dividend imputation system.

4.2 Income/capital distinction and CGT discount concession for capital gains

While the income tax law generally operates on the basis that all income, profits and gains from commercial activities should be subject to tax, the tax law has always drawn an important distinction between “ordinary income” and “capital gains”. In general, capital gains have received a concessional or preferential treatment relative to ordinary income.

In the context of intellectual property commercialisation involving a spin-off company, “ordinary income” would include wages and salaries, interest, rent, royalties, licence fees and dividends. These

31 Income tax liabilities are calculated pursuant to the ITAA 1936 and ITAA 1997. 32 Non-resident companies are generally subject to tax only on income, profits or gains sourced in or connected with

Australia: s 6-5 and Division 136 of the ITAA 1997.

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items would be taxed in the hands of their recipients at the normal tax rate. By contrast, “capital gains” would include gains on the disposal of “capital” investments such as assets held for purposes of long-term investment, rather than trading or profit-making by resale. Such capital gains attract concessional treatment.

hile if it is an Australian complying superannuation fund, only 66% of the gain will be subject to tax.

ployee shares and options. To the extent it applies to them, it enhances their value to the employees.

4.3 Tax treatment of grants and subsidies

ible for such forms of assistance. The tax treatment of grants and subsidies will therefore be relevant.

business to be taxable income and “subsidy” can include a financial grant by a government.35

In particular, special tax concessions apply to capital gains on disposals of shares – the “CGT discount”. Should the shareholders dispose of their shares in the spin-off company, capital gains on the disposal will normally be subject to tax in Australia. But if the shareholder is an individual who has held the shares for at least 12 months, only 50% of the capital gain will be subject to tax, w

The “CGT discount” is also relevant to em

Governments at both state and federal levels offer programs of grants and subsidies designed to foster commercialisation of innovative technology (see, for example, those listed in Appendix A). Companies engaged in commercialisation of intellectual property may be elig

In general, a grant or subsidy received in the ordinary course of business will be treated as ordinary taxable income.33 This will be so, even if the grant or subsidy is received to assist with capital expenditures.34 Where a grant or subsidy is not ordinary income, section 15-10 of the ITAA 1936 may deem it to be taxable income; it deems a bounty or subsidy received in relation to carrying on a

Subjecting grants to federal income tax can be a problem where state governments wish to use grants to encourage local companies and industry – potentially, up to 30% of the grant may be transferred to the federal government as a tax payment. As a practical matter, where grants are received by a spin-off company, tax liability can be avoided if the moneys are applied immediately (ie in the same tax year as the year of receipt) to deductible expenditure in the business. This practical solution is not, however, always available; in particular, problems can arise where:

(a) grants are received to fund expenditure for which the tax-system does not allow a deduction;

(b) grants are received to fund expenditure which will only be incurred over a period of years; or

(c) ed to fund capital expenditure for which the deductions are spread over a period of years.

ture, can result in a tax liability, reducing the effective value of the grant.

“up-front”

grants are receiv

In such cases, the delay between the time of receipt of the grant, and the time at which deductions (if any) are recognised for the corresponding expendi

33 Rekit & Colman Pty Ltd v FCT (1974) 4 ATR 501; AAT Case 9472 (1994) 28 ATR 1155; Case 22/94 ATC 225. 34 GP International Pipecoaters Pty Ltd v FCT (1990) 170 CLR 124. 35 First Provincial Building Society Ltd v FCT (1995) 56 FCR 320.

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General tax regime for intellectual property commercialisation by a spin-off company

Another problem for government grants concerns their interaction with the R&D concession (see further at 6.1 below). Where a grant recoups expenditure on research and development for which deductions have been claimed under the R&D concession, the receipt of the grant will effectively require a reversal of the concessional R&D deductions for income tax purposes.36 This again reduces the effective value of the grant.

on activity is the taxation treatment of expenditure on the activity. In particular, the question of tax deductions or other tax relief for the expenditure will

A significant problem under current tax law is the lack of comprehensive and systematic tax relief for

The key inputs that are contributed to an IP spin-off company, either initially or during the course of

between “revenue” and “capital” expenditure. In general revenue expenditure is deductible immediately. Tax relief for capital expenditure, by contrast, is deferred or, in some cases,

secrets and confidential information. Intellectual property of this kind will generally constitute a capital asset of the intellectual property creators, and of the spin-off

ly sold. If the intellectual property is not treated as a CGT asset at all (for example, trade secrets or confidential information) then there is unlikely to be any recognition of its cost for tax

be recognised only as part of the cost base of the intellectual property asset that is generated by the

4.4 General tax treatment of expenditure on intellectual property

Of particular importance to commercialisati

determine the overall return on the project.

capital expenditure on IP commercialisation.

its operation, are:

(a) the intellectual property assets; and

(b) the labour (skills and expertise) of IP originators and developers.

Tax law distinguishes

simply not available.

Intellectual property that is the product of scientific or innovative research and development by individuals and institutions is protected by the laws relating to copyrights, patents, designs, plant breeders rights, circuit layouts, trade

company, for income tax purposes.37

Expenditure incurred by a spin-off company or other commercialisation vehicle to develop or acquire a capital asset is thus generally treated as capital expenditure. This means it is not deductible unless it can be brought within specific capital allowance rules, discussed below. If it cannot be brought within a capital allowance rule, the acquisition cost will generally be recognised at best as forming part of the cost base of an asset for CGT purposes, and offset against sale proceeds only if the asset is subsequent 38

purposes.

For the initial creator or developer of intellectual property, the costs of labour, time and even acquired inputs (equipment, power, laboratory use and so on) for self-created or developed intellectual property will not be deductible unless the intellectual property is created as part of an existing business activity for the purpose of producing assessable income.39 Even then, such costs may be treated as capital and

36 See section 73C of ITAA 37 Section 108-5 of the ITAA 1997. 38 Division 110 of the ITAA 1997. 39 Section 8-1 of the ITAA 1997.

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work. For example, the costs of a scientist or inventor who is not already engaged in a business, but who works alone or with a university, are not tax deductible and will at best form part of the cost base of an intellectual property asset if and when it is eventually sold, eg to a spin-off company.

are treated as incurred exclusively on the development of capital assets or other structural assets.40

ible to the spin-off company, however, even though they will ordinarily be assessable to the recipient.

or equivalent rights under a foreign law.42 The effective lives are prescribed by statute, namely:43

Once a spin-off company is formed to commercialise the intellectual property, labour costs and other recurrent inputs will generally be treated as revenue expenditure deductible to the spin-off company on an annual basis. However, there may be circumstances when these costs are not deductible as revenue expenditure because they

Problems also arise with non-cash remuneration. Forms of remuneration other than salary and wages, in particular shares or options, are likely to be common in a spin-off company that is cash-poor. The value or cost of these forms of remuneration will not be deduct

4.4.1 Capital allowances regime

The income tax law includes a ‘capital allowances’ regime41 which allows depreciation deductions for capital expenditure on certain kinds of capital assets to be written off over the effective life of the asset. The regime extends to ‘intellectual property’, but for income tax purposes the term ‘intellectual property’ is given a narrow definition. It only includes certain forms of intellectual property, namely patents, designs or copyrights – or, to be more precise, legal or equitable rights as owner or a licensee in relation to patents, registered designs and copyrights recognised under Commonwealth law (including software copyright),

Asset Effective life Standard patent 20 years Innovation patent 8 years Petty patent 6 years Registered design 15 years Copyright Shorter of 25 years or period until ends A licence (not relating to copyright or in-house software) Term of licence A licence relating to copyright 25 years or period until licence ends Shorter of In-house software 2.5 years

e lives will correspond to the actual period over which the intellectual property declines in value to nil.

adjustment event” under the Capital Allowances regime. If the sales proceeds exceed the depreciated

The fixed effective lives set the period over which the cost of the patent, design or copyright must be depreciated or ‘written off’ for taxation purposes, and the income tax law presumes that these prescribed effectiv

When patents, designs or copyrights are sold, this is treated as a taxable event, called a “balancing

40 Goodman Fielder Wattie v FCT (1991) 29 FCR 376; 91 ATC 4438 (Hill J). 41 Division 40 of the ITAA 1997. 42 See s 995-1(1) definition of ‘intellectual property’ in ITAA 1997. 43 Section 40-95 of the ITAA 1997.

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value of the asset at the sale time, the excess is taxed as ordinary income. If the sale proceeds are less than the depreciated value, the deficit can be claimed as a deduction.

4.4.2 Trade secrets, know-how and confidential information

There is no capital allowance depreciation for expenditure on trade secrets, know-how and confidential information, as they are not regarded as depreciating assets (subject to a limited exception for mining, quarrying and prospecting information, relevant to the natural resources industry). Trade secrets, know-how and confidential information are also generally not regarded as “CGT assets” for capital gains tax purposes. The distinction in fiscal treatment between, on the one hand, copyright, patents, and registered designs, and, on the other hand, confidential information and trade secrets, has its origin in the legal principle that the former are recognised as forms of legal property, while the latter are not, under Australian law.44

The fact that trade secrets, know-how and confidential information are not a form of property, in the conventional legal sense45, leads to confusion in determination of their taxation treatment. The confusion has affected both the appropriate characterisation of expenditure incurred in developing such assets, and appropriate taxation of money received for the exploitation or sale of such assets.

In practice, the development of this type of “intangible non-property capital” tends to take place gradually over a long period, often as a by-product of other activity, and depends in large part on the intellectual labour of knowledge workers who are paid regular wages and salaries. In practice, companies tend to treat expenditure on wages and salaries as an immediately deductible revenue expense, so the practical outcome is that the cost of developing trade secrets, know-how and confidential information is allowed as a revenue deduction as the relevant wage and salary expense is incurred.46 Where, however, a company pays a single sum to make an outright “purchase” of such an asset which has been developed by another person, intending to use the asset as a capital asset in the business, it would ordinarily be expected that the purchase price would be treated as a non-deductible capital expense, even though no “legal property” has been acquired as a result of the expenditure.47

In the case of commercial exploitation or sale of know-how, trade secrets and confidential information, the fact that such assets are not “legal property” means that, strictly speaking, they cannot be “sold”, “assigned” or “disposed of” to other parties. Thus, the means by which know-how, secrets or information is made available by one person to another is ordinary characterised as a supply of a service.48 Amounts received as consideration for the supply of services are invariably treated as “ordinary income”, and subject to taxation as such, rather than as capital gains.

Nevertheless, it is recognised that, in exceptional cases, a party might effect an outright “disposal” of trade secrets, know-how or confidential information which should not be characterised as a mere supply of a service. For example, if a party effectively divests itself of all rights with respect to know-how or trade secrets on the sale of a business in which such confidential information has been a capital

44 See Taxation Ruling TR 93/8, “Treatment of Receipts for Dealing with or Disclosing Mining, Quarrying or

Prospecting Information”. 45 c.f. Gummow J in Hepples v FCT 90 ATC 4497 at 4520, where it is argued that the degree of legal protection

afforded by the legal system to confidential information makes it appropriate to describe it as having a proprietary character, not because this is the basis on which that protection is given, but because this is the effect of that protection.

46 See the discussion of Hill J in Goodman Fielder Wattie v FCT 91 ATC 4438. 47 See Sun Newspapers Ltd v FCT (1938) 61 CLR 337, especially the judgement of Dixon J. 48 Brent v FCT (1971) 125 CLR 418. TR 98/3 paragraphs 19, and 45 to 52.

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asset, this will be characterised for taxation purposes as a disposal of a capital asset, and the money received will be treated as capital rather than income.49 In addition, because such confidential information is not regarded as an “asset” for capital gains tax purposes, amounts received for the “disposal” of the confidential information will generally be tax-free capital receipts.50

In many cases therefore, when parties are dealing with intellectual property of this kind, it will also be necessary to distinguish between a mere supply of services and an outright “disposal” of intellectual property.51

There is, however, an important exception to this. Where the confidential information has been generated by expenditure the subject of deductions under the R&D Concession (see 6.1 below), any amount received for its disposal will be taxable income.52

4.4.3 Tax treatment of commercialisation transactions involving intellectual property

In Chapter 3 it was noted that, apart from formation of an IP spin-off company, there are other methods of generating commercialisation revenues from intellectual property (see 3.1). Their tax treatment can be briefly reviewed:

Source of commercialisation revenue Tax treatment Revenues from use of intellectual property to provide services such as contract R&D work

Revenues from services are taxed as ordinary income. Intellectual property used to provide services may generate deductions under capital allowances regime if patent, copyright, design or in-house software (see 4.4.1 above).

Licensing of intellectual property to third parties in exchange for royalties or license fees.

Royalties or licence fees are taxed as ordinary income:53 Licensor may have deductions under capital allowances regime if intellectual property is patent, copyright or design (see 4.4.1 above).

Sale of intellectual property to third parties for cash consideration by way of up-front cash payment.

If intellectual property is patent, copyright or design, sale is a taxable “balancing adjustment event” under capital allowances regime. Proceeds are taxable at ordinary income rates to the extent they exceed the “adjustable value” of the intellectual property. The “adjustable value” will be its original cost, less capital allowance depreciation to the date of sale (see 4.4.1 above as to depreciation). If intellectual property is an asset for which deductions under the R&D concession have previously been claimed, proceeds will be taxed at ordinary income tax rates (see 6.1 below). If intellectual property is confidential information, trade secret or know-how, and has not been the subject of deductions under the R&D concession, sale proceeds may be tax-free (see 4.4.2 above).

Sale of IP to third parties for deferred payments by way of royalties.

Royalties are taxed as ordinary income.54

Receipt of government grants or subsidiaries. Generally taxed as ordinary income (see 4.3 above).

49 See Evans Medical Supplies Ltd v Moriarty (1957) 37 TC 540 and cf Rolls-Royce Ltd v Jeffrey (1962) 40 TAC 443,

and Murray v ICI Ltd (1967) Ch 1038. 50 See TR 98/3 paragraphs 60 to 81. 51 See Studies on International Fiscal Law, Volume LXXXIIa, The taxation of income derived from the supply of

technology, IFA, 1997/ 52 See section 73B (27A) of ITAA 1936 and 6.1 below. 53 See IT 2660 and Stanton v Commissioner of Taxation (1955) 92 CLR 630. 54 ICI Ltd (1967) Ch 1038.

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4.5 Stamp duty

All States and Territories impose stamp duty on transfers of property which is located within, or otherwise sufficiently connected to, their jurisdiction.55 Stamp duty is imposed at ad valorem rates on the unencumbered market value of the property. Current maximum rates are:

Value at which max rate commences Maximum rate Victoria 870,000 5.5% NSW 1,000,000 5.5% Qld 500,000 3.75% SA 500,000 5.5% WA 500,000 5.4% Tasmania 225,000 4% NT 500,000 5.4% ACT 1,000,000 6.75%

4.5.1 Historical duty position of intellectual property

The application of stamp duty to dealings in intellectual property has historically been complex. One problem concerns the fact that the duty traditionally applied to transfers of ‘property’ in the legal sense. This meant. for reasons discussed above, that the duty did not apply to dealings in trade secrets, know-how and confidential information which were not in the form of ‘property’. On the other hand, duty could potentially apply to dealings in recognised forms of legal ‘property’ such as copyright, patents, registered designs, goodwill and registered trademarks.

A second problem concerns the requirement that the property be located in, or otherwise have a relevant ‘nexus’ with, the State or Territory imposing duty. Recognised forms of legal property such as copyright, patents, registered designs or registered trade marks arise by virtue of statutes of the Commonwealth Parliament, and hence do not necessarily have a nexus with any particular State or Territory within the Commonwealth.56

4.5.2 Recent duty reforms on intellectual property

Recent stamp duty reforms have now brought some clarity to the treatment of intellectual property dealings. Victoria does not impose duty on intellectual property assets. In the other jurisdictions, no duty will apply to transfers of intellectual property such as copyright, patents, registered designs, know-how, confidential information and registered trade marks, except where the intellectual property is effectively being transferred or assigned as part of the sale or transfer of a business which is using the intellectual property as an asset of the business.

In such a case, if the relevant business is being conducted wholly in a particular State or Territory, that State or Territory can impose duty on the total value of the business, including the intellectual property

55 Duties Act 1997 (NSW); Duties Act 1999 (ACT); Duties Act 2000 (Vic); Duties Act 2001 (Tas); Duties Act 2001

(Tas); Duties Act 2001 (Qld); Stamp Duties Act 1923 (SA); Stamp Act 1921 (WA); Stamp Duty Act 1978 (NT). 56 See Zumbo, “Stamp Duty on Intellectual Property Transactions: Contemporary Issues”, Australian Tax Review, Vol

23 (June 1994), p.85.

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assets. If the business is being conducted in two or more States or Territories, the duty on intellectual property referable to each State or Territory will generally be apportioned by reference to the relevant level of business activity in each jurisdiction, ordinarily measured by sales.

In consequence, the question of whether a dealing in intellectual property attracts stamp duty will ordinarily involve the consideration of two matters:

(a) whether the intellectual property is an asset of a business being carried on by the owner of the intellectual property; and

(b) if so, whether the dealing involves a transfer of all or part of that business.

This means that stamp duty can apply to transactions related to the commercialisation of intellectual property; for example, where intellectual property of an existing business is transferred with other assets of the business into a spin-off company.

4.5.3 Stamp duty and shares

Stamp duty can also apply to dealings in shares in a spin-off company. While Victoria, Western Australia and Tasmania have abolished duty on transfers of shares, the other jurisdictions still impose it on transfers of shared in companies not listed on the stock exchange at 0.6% of the unencumbered value of the shares.

Transfer duty generally applies only to shares in companies incorporated in the jurisdiction imposing the duty. Hence, from a stamp duty perspective, it appears desirable that spin-off companies be incorporated in Victoria, Western Australia or Tasmania. Further, the fact that Victoria does not impose duty on intellectual property assets probably makes it the more desirable of these three jurisdictions.

4.6 Goods and Services Tax

Since 1 July 2000 the goods and services tax (GST) has applied at 10% to consideration provided for the ‘supply’ of goods, services and other benefits by business enterprises in Australia.57 It extends to consideration for the supply of intellectual property, or rights with respect to intellectual property. Hence it will apply to most dealings concerned with the commercialisation of intellectual property.

It will also apply in some, but not all, cases where an entity engaged in intellectual property commercialisation receives a grant, subsidy or incentive from either a government or private entity. The grant, subsidy or incentive may be treated as consideration received by the payee for the supply of benefits to the payee where the payee is obliged to provide some benefit, or perform some service, as a condition of the grant, subsidy or incentive.58

There are limits to the application of GST. In general, GST will only be imposed if the person making the supply its ‘registered’ for GST purposes, and registration is only required if an entity is carrying on an ‘enterprise’ and has annual turnover in excess of $50,000.

57 A New Tax System (Goods and Services Tax) Act 1999 (Cth). (GST Act). 58 GSTR 2000/11.

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In general, if both parties to a transaction are ‘registered’ for GST, the party to whom the supply is made will be entitled to claim an ‘input tax credit’ for the GST imposed on the consideration: this credit is effectively a tax refund of the GST. This means that, in practice, if the parties ‘gross-up’ the actual consideration for the supply by an additional 10% for GST, the net transaction cost of the GST is zero: the party making the supply will receive the additional 10% and remit it to the Tax Office, and the party receiving the supply will claim back the additional 10% as an input tax credit.

In consequence, a spin-off company will ordinarily elect to register for GST purposes so that it can claim input tax credits on supplies made to it, and allow its suppliers to “gross-up” for GST in the manner indicated. Problems can arise, however, where one of the parties to a transaction is not registered for GST. In such a case, GST may become a net cost for the transaction of 10%. This can occur, for example, where an overseas entity is transacting with an Australian enterprise. In the context of intellectual property commercialisation, a typical instance would be where a spin-off company grants a licence of intellectual property with royalties to an overseas company (or alternatively, takes such a licence from an overseas company).

Dealings with overseas companies raise the question of how GST applies to ‘cross-border’ transactions. In general, ‘exports’ of goods and services by an Australian enterprise to an overseas company should be GST-free. On the other hand, ‘imports’ of goods and services will generally attract GST at 10%. In either case, however, the operation of GST is subject to an over-riding territorial requirement that there must be a supply which is “connected with Australia” in the relevant sense.59 This is a matter of considerable complexity. In the case of dealings in intellectual property rights, the relevant “connection” with Australia will ordinarily arise if either the rights are created in Australia, or the rights are supplied by an enterprise with a permanent establishment in Australia.60 Hence, in the case of dealings in intellectual property with overseas companies, there may be GST advantages in having the relevant contractual rights created outside Australia.

4.7 Other labour taxes

Since the commercialisation of intellectual property will typically involve significant input of skilled labour, it will ordinarily be relevant to consider the potential impact of other labour taxes. In Australia, these will include:

(a) income tax on employee salary, with a top marginal rate of 47%;

(b) Medicare levy, with a top rate of 1.5%;

(c) fringe benefits tax at 47% on non-money benefits supplied to employees;

(d) Superannuation guarantee levy, at 9%, on salary;

(e) State payroll taxes, at various rates of up to 6.85%61 - but generally smaller businesses with total payrolls under prescribed limits are exempt,62 which may provide relief for intellectual property start-up companies; and

59 GST Act, s.9-25. 60 GSTR 2000/31. 61 NSW: 6.0%; VIC: 5.25%; Qld: 4.75%; WA: 5.5%; SA:5.5%; Tas: 6.1%; NT: 6.2%; ACT: 6.85%. 62 NSW: $600,000; Vic: $550,000; Qld: $850,000; WA: $750,000; SA: $504,000; Tas: $1,010,000; NT: $800,000;

ACT: $1,250,000. Source: ATP Australian Tax Handbook 2005 [para. 64 060]

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(f) workers compensation levies and premiums.

These additional labour taxes can influence the structure of intellectual property commercialisation arrangements, since they add to the cost of labour. They create an incentive for labour inputs to be provided under legal arrangements which do not attract the taxes. To the extent that some of the taxes do not apply to “independent contractors”, for example, they may provide an incentive to structure labour arrangements as contractor rather than employee arrangements. To the extent certain forms of remuneration such as employee shares may not attract certain state taxes, there may be an incentive to structure remuneration accordingly.63

63 For example, employee shares are included in payroll tax in NSW, WA and NT, but not Vic, Qld, SA, Tas or ACT:

[ATP Handbook, para 64 050].

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Chapter 5 Intellectual property commercialisation and role of special tax concessions

The ordinary operation of the income tax law will be to expose the income, profits and gains derived from commercialisation of intellectual property through a spin-off company to income tax liabilities. The prospect of suffering income tax on the income, profits and gains generated by a commercial activity may no doubt be regarded as more likely to discourage, rather than encourage, entry into commercialisation activities. This, however, is a general feature of any income tax regime and hence it cannot be a specific obstacle to intellectual property commercialisation.

Of more direct relevance to this Working Paper is the role played by special tax concessions in relation to the development and commercialisation of intellectual property. This Chapter and the next consider those issues in more detail.

5.1 Basis of general case for special concessions

It is generally argued that, because commercialisation of intellectual property generated by research and development is a form of entrepreneurial activity which is typically subject to abnormally high levels of business and financial risk,64 the negative effect of taxation is higher in relation to commercialisation of intellectual property than it is in relation to other business activity considered to have lower risk (such as passive investment in shares and real estate).65 If so, there may be an argument for offsetting those special risks by granting special tax concessions and reliefs to entrepreneurial activity associated with intellectual property commercialisation. The literature suggests that commercialisation of intellectual property is important to ensure that the national economy continues to benefit from technological innovation.66

There is controversy as to whether tax incentives or concessions may increase the level of investment in that activity to an optimal level, or indeed to any extent over what would have been done otherwise. There is however, a respectable literature that suggests that tax policy, either the basic tax framework

64 As stated by Christian Keuschnigg, “Public Policy and Venture Capital Backed Innovation” (October 2003) CESifo

Working Paper No 1066, “innovative young firms have high potential but are very risky as well. Developing a business idea into a new marketable product involves formidable technological and managerial risks” (p.1).

65 The negative effect appears to relate in particular to entry into start-up or entrepreneurial activity: William M Gentry and R Glenn Hubbard, ‘“Success Taxes”, Entrepreneurial Entry and Innovation’ (June 2004) National Bureau of Economic Research Working Paper 10551; Robert Carroll, Douglas Holtz-Eakin, Mark Rider and Harvey S Rosen, “Entrepreneurs, Income Taxes and Investment” (1998) NBER Working Paper 6374.

66 OECD Directorate for Science, Technology and Industry, Entrepreneurship and Growth: Tax Issues (YEAR), Australian Institute for Commercialisation, The economic impact of the commercialisation of publicly funded R&D in Australia (4 September 2003);. See also Federation of Australian Scientific and Technological Societies (FASTS), Australian Science: Investing in the Future (Policy Paper) (September 2002), p.9; Chief Scientist, The Chance to Change, Department of Industry, Science and Resource (Nov 2000), p.81. See also “Business Commitment to Research and Development in Australia”, a submission to the House of Representatives Standing Committee on Science and Innovation from the Non-Ministerial members of the Council for Knowledge, Innovation, Science and Engineering (VIC), August 2002. The evidence suggests that it is the activities of the spin off companies themselves, rather than the University or publicly funded R&D, that benefits the economy most: AIC Report, p.7. This implies that the tax treatment of those spin off companies is important.

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for entities, or specific tax incentives, will affect investment patterns and choices of investment as between different activities.67

There is also dispute as to the kinds of incentives which are most effective - for example, a subsidy for start-up costs, versus a reduction in taxation of capital gains in the event of an ultimately successful commercialisation.68 It has also been suggested by Jeng and Wells in their comparative study that each stage of venture capital should be considered separately for analytical and public policy purposes.69 This suggests that, by analogy, the appropriate public policy, including tax policy, may differ for each stage of intellectual property commercialisation.

It is beyond the scope of this Working Paper to debate the arguments for and against tax concessions and other government assistance for intellectual property activity. For present purposes, it is sufficient to note that, where tax assistance is given, the policy basis for that assistance must rest on the general argument that, first, it is desirable on social and economic grounds to increase the level of investment in that activity, and second, absent such assistance, there would be less investment in that activity. If these two propositions are presumed to be true, then it must follow that it is important to understand how the tax assistance is intended to increase investment in an activity, within the context of the existing tax system.

5.2 How do tax concessions increase investment in an activity?

It may be presumed that the probability a person will make a decision to invest in any particular commercial activity, will vary in proportion to the level of commercial returns expected to be generated from that activity, after all taxes have been paid. The purpose of granting a tax concession to a specific activity is to increase the probability of a decision to invest in that activity, by increasing the level of after-tax returns which might be expected from the activity.

Tax measures can, in principle, increase the level of after-tax returns from a specific activity in two ways:

(a) first, by reducing the after-tax cost of expenditure on the activity, by offering special tax deductions or tax rebates for that kind of expenditure;

(b) second, by increasing the after-tax value of economic income from the activity, by offering special tax reductions or tax reliefs for income, gains or profits earned from investment in that kind of activity.

Both kinds of measure can be found operating in the Australian tax system in relation to intellectual property:

67 The view that tax policy will have an effect on economic growth and can change the level, timing and composition

of investment is supported by economic literature applying modelling techniques to empirical data; see for example Robert E Hall and Dale W Jorgenson, “Tax Policy and Investment Behaviour” (1967) 57 American Economic Review 391; Eric Engen and Jonathan Skinner, “Taxation and Economic Growth” (1996) 49 National Tax Journal 4. In Australia, this view is affirmed in the Review of Business Taxation, A Tax System Redesigned (1999) p.13 [24]-[30].

68 A capital gains tax reduction is recommended by the House of Representatives Standing Committee on Science and Innovation, Riding the Innovation Wave (June 2003), Recommendation 15.

69 Jeng and Wells, ibid p.242.

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Intellectual property commercialisation and special tax concessions

(a) first, the R&D concession aims to increase levels of investment in research and development by reducing the after-tax cost of that kind of expenditure through a special 125% deduction, or in some cases, tax rebate of equivalent value;

(b) second, concessional tax rates for capital gains from venture capital activity, including (but not limited to) capital gains derived from intellectual property commercialisation, are intended to increase investment in such activity by increasing the after-tax value of gains from such activity.

These are discussed in the next Chapter.

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Chapter 6 Special tax concessions relevant to intellectual property in Australia

In Australia, the argument that entrepreneurial activity associated with intellectual property is of sufficient social importance to justify more favourable tax treatment designed to offset the associated commercial risks, appears, to a certain extent, to have been accepted. Australian income tax law has for some time offered special tax concessions relevant to intellectual property research and development and commercialisation activity.

One of these concessions operates at the first stage of intellectual property creation, in the form of special deductions and rebates for research and development expenditure by approved companies (the R&D concession)70. The others, being the more recently enacted tax concessions for equity investment in entrepreneurial activity in PDFs and VCLPs, will be beneficial at a later stage, where significant commercialisation profits are produced. They are both discussed in this Chapter.

6.1 The R&D Concession

The objects of the R&D concession are stated to include ‘encouraging the development by eligible companies of innovative products, processes and services’ and ‘creating an environment that is conducive to increased commercialisation of new processes and product technologies developed by eligible companies’.71 However, the purported object of increasing commercialisation is only poorly reflected in the actual working of the concession.

The R&D concession operates primarily, as its name would suggest, at the initial phase of research and development.

It generally allows a concessional tax deduction to companies registered with the IR&D Board72 for certain kinds of expenditure on eligible research and development activities. Small companies may obtain a cash rebate in lieu of the deduction.73

As discussed further below, eligible ‘research and development activities’ are defined for these purposes to mean ‘systematic, investigative and experimental activities’ which involve innovation or high levels of technical risk, and are carried on for the purpose of acquiring new knowledge or creating new or improved materials, products, devices, processes or services74.

The general idea is that the R&D needs to concern a technical problem which cannot be resolved on available information, original ideas or experimentation. While part of the intellectual property commercialisation activity of a spin-off company may still be sufficiently early in the development phase to qualify for the R&D concession, ordinarily the parties to an intellectual property commercialisation partnership would be hoping to progress beyond the stage at which the intellectual

70 Section 73B of the ITAA 1936. 71 Section 73B(1AAA) of ITAA 1936. 72 Companies must register with the IR & D Board, and must also have the IR &D Board approve their R&D Plan. 73 Generally the company must have turnover of under $5 million and R&D expenditure of no more than $1 million

for a year. Turnover and expenditure of associates is also taken into account. 74 Section 73B(1) and (2A),(2B) and (2C) of the ITAA 1936.

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property has the character of an unsolved technical problem or experimental investigation.75 As discussed below, this narrow definition of R&D accordingly places significant limits on the extent to which the R&D concession can actually support commercialisation activity.

6.1.1 General operation of R&D concession

Eligible expenditure on research and development may, in general, qualify for a deduction of up to 125% of the actual expenditure. So, for example, if a company incurs $100 of eligible R&D expenditure, it can claim a tax deduction of $125 (which, at a company tax rate of 30% has a prima facie tax value of $37.50).

A deduction of up to 175% for increases in non-plant expenditure may apply where a company increases its R&D expenditure on salary or other non-plant items above the average expenditure over the previous 3 years. So, for example, if a company increases its expenditure above the annual average by $100, it can claim a deduction of $175 in respect of that increase.

As an alternative to R&D deductions, which are of immediate value only if a company has income against which it can claim the deductions, certain small companies may instead claim the R&D tax offset. This, in effect, is a cash tax refund of an amount equal to the tax value of the deduction. So, for example, if a small company has R&D expenditure of $100, it can claim a tax rebate of $37.50.

The R&D concessions are provided through the income tax system, but administered by the Australian Taxation Office in conjunction with the Industry Research and Development Board (IR&D Board).76

6.1.2 In generally only companies are eligible

The R&D concession ordinarily applies only to expenditure incurrent by ‘eligible’ companies, which are defined to be companies incorporated in Australia. With limited exceptions, it is not available to partnerships77 or trusts;78 and it is not available to individuals. The following discussion concerns R&D of companies incorporated in Australia.

A company must register with the IR&D Board on an annual basis to claim the R&D concession. The company must also conduct its R&D pursuant to a research and development plan which meets guidelines set by the IR&D Board.79

A company can claim the R&D concession for an R&D project it conducts itself. It can also claim it for R&D work contracted out to other parties, or a registered research agency, provided the work

75 The OECD, FASTS and other parties have recommended extending R&D tax concessions to the development end

of the R&D process. See OECD, Tax Incentives for Research and Development: Trends and Issues (2003) at p.29; Gascoigne, Toss and Metcalfe, Jenni, “Scientists Commercialising Their Research”, April 1999, FASTS “Barrier 6”; The Chance to Change, ibid.

76 See Australian Tax Handbook 2005 (ATP, 2005), para 21 020, Guide to the R&D Tax Concession (August 2004) at http://www.ausindustry.gov.au; ss73B – 73Z of ITAA 1936; and Part IIIA of Industry Research and Development Act 1986 (IRD Act).

77 A partnership comprised of companies may qualify, as may a partnership between companies and a registered research agency; or a corporate limited partnership.

78 Certain public trading trusts may qualify. 79 Section 73B(2BA).

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Special tax concessions relevant to intellectual property In Australia

contracted out is conducted on behalf of, for the benefit of subject to the control of, and at the risk of, the company.80 The following discussions concerns R&D undertaken by the company itself.

6.1.3 Different types of expenditure

The concession operates differently on different kinds of R&D expenditure. One category is ‘contracted expenditure’ for R&D work done by the Coal Research Trust Account or registered research agencies. A second category is ‘salary expenditure’ on employees engaged in R&D activities. A third category is ‘other expenditure incurred directly in respect of R&D activities’ of the company.

6.1.4 Definition of ‘R&D activities’

All three categories rely on the company having incurred the expenditure on ‘research and development activities’, or ‘R&D activities’, as defined in s 73B(1) of the ITAA 1936.

A review of the definition indicates that the primary focus of the concession is on the initial phase of research and development intended to generate ideas with commercial potential, rather than later phases of commercialisation activity.

The definition encompasses ‘core’ and ‘supporting’ activities. ‘Core’ R&D activities are defined to be ‘systematic, investigative and experimental activities’ that involve ‘innovation’ or ‘high levels of technical risk’. They must be carried on for the purpose of ‘acquiring new knowledge (whether or not it will have a specific practical application or creating new or improved materials, products, devices, processes or services’. ‘Supporting activities’ are those carried on for a purpose ‘directly related’ to the carrying on of the core R&D activities.

R&D activities will not have the required level of ‘innovation’ unless they involve ‘an appreciable element of novelty’.81 The alternative test of ‘high levels of technical risk’ will not be met unless ‘the probability of obtaining the technical or scientific outcome cannot be known or determined in advance on the basis of current knowledge or experience’, and the uncertainty can only be removed ‘through a program of scientific, investigative and experimental activities’ which apply ‘scientific method’ in a systematic progression of work ‘from hypothesis to experiment, observation and evaluation, followed by logical conclusions’.82

6.1.5 “R&D activities” generally do not include commercialisation activity

This conception of eligible R&D activities will not include very much by way of expenditure on commercialisation of intellectual property. Some expenditure in the early phase of development of ideas, knowledge and inventions may possibly be eligible. However, much will be ineligible.

In addition, certain commercialisation activity is expressly excluded from the statutory definition of R&D activities: market research, market testing or market development; sales promotion (including consumer surveys); pre-production activities such as demonstration of commercial viability, tooling-

80 Sections 73B(1B), 73B(3) and 73B(9); IT 2442 and IT 2451. 81 Section 73B(2B)(a). The EM refers to seeking previously undiscovered phenomena, structures or relationships;

attempting to apply techniques or knowledge in a new way: activities likely to result in patentable or other protectable Intellectual Property.

82 Section 73B(2B)(b).

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up and trial runs; or commercial, legal and administrative aspects of patenting, licensing or other activities.83

Work on computer software also cannot qualify unless developed for the purpose, or a purpose, of sale, licence or lease to third parties.84

6.1.6 Other limitations

In general, R&D activity must be carried out in Australia; a deduction for overseas expenditure requires a certificate from the IR&D Board and cannot exceed 10% of total expenditure. Deductions for expenditure on ‘core technology’ used in R&D activities are also limited, in general, to one-third of the related R&D expenditure.85 ‘Interest expenditure’ on funds used in R&D, and expenditure on ‘feed stock’ used in R&D, is deductible at normal rates, rather than the R&D concessional rate. ‘R&D plant’ is eligible for concessional treatment: the company can deduct the ordinary tax depreciation at 125%. Pre-paid expenditure is generally not wholly deductible in the year of expenditure, but must be partly deferred over the period to which it relates.86

6.1.7 Constraints on commercialisation when R&D concession has been claimed

The IR&D Board has the power to issue certain certificates in relation to an R&D project which have the practical effect of cancelling the R&D tax concession. These powers can also constrain commercialisation activity in relation to R&D. The certificates include:

(a) a certificate that the R&D project lacks adequate ‘Australian content’ – to avoid this, key personnel should ordinarily be Australian citizens or permanent residents, and key technology and plant should ordinarily be of Australian origin;

(b) a certificate that the results of an R&D program have not been exploited on ‘normal commercial terms’ – to avoid this, the commercial exploitation needs to be on terms which would arise from parties dealing at arm’s length with comparable bargaining power;

(c) a certificate that the exploitation of the results has not been “for the benefit of the Australian economy” – to avoid this, the profits or gains to Australian residents accruing directly from the exploitation of a significant aspect of the results must be commensurate with the amount expended on the activity’.87

This third certificate can pose considerable problems for commercialisation of technology, where it will often be desirable to undertake commercialisation activity overseas to access larger overseas markets and the technical resources of foreign companies.

83 Section 73B(2C). 84 Section 73B(2A). 85 Section 73B(12A). 86 Section 73B(11). 87 ATP, para [21 110].

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Other limitations relevant to commercialisation include the requirement that the company be ‘at risk’ in relation to R&D expenditure88 - structured financing arrangements which guarantee commercial returns to investor’s are not permitted.

6.1.8 Tax treatment of commercialisation proceeds when R&D concession claimed

While the R&D concession provides an incentive to incur expenditure on R&D activities, it has consequences for any subsequent commercialisation of the results of the R&D activities. In general:

(a) any amount received in respect of the results of the activities; and

(b) any amount attributable to the company having incurred the expenditure,

will be taxable income to the company.89

This includes amounts received for granting access to, or rights to use, results of the activities.90 Such amounts are assessable as revenue rather than capital gains.

The R&D concession also has consequences for government grants (and other forms of recoupment) received in relation to R&D activities. Such grants operate to ‘claw-back’ the deduction for the R&D expenditure. An amount equal to twice the grant has its deduction reduced from 125% to 100% only.91

6.1.9 Additional 175% premium deduction for above average non-plant expenditure

The general concessional rate of deduction for R&D is 125% of the actual expenditure – i.e. if a company incurs $100 R&D expense, it obtains a tax deduction of $125.

However, where a company increases its R&D expenditure (on non-plant items) for a year above its average annual expense (on non-plant items) for the preceding three years, it may claim a deduction at 175% for so much of the increased expenditure as does not relate to the lease, hire or acquisition of plant.92

6.1.10 R&D tax offset for small companies

The concessional deduction is of value to a company only if it can apply the deduction to reduce income tax payable on other income. For start-up companies, there will often be no such other income, meaning the R&D deduction provides no immediate value.93 To correct this outcome, limited relief is given to smaller enterprises: companies with R&D expense of not more than $1,000,000, and turnover of less than $5,000,000, may convert the deduction to a cash tax refund (equal to 30% of the deduction) under the ‘R&D tax offset’ rules.94

88 Sections 73CA, 73CB. 89 Section 73B(27A). 90 Section 73B(27B). 91 Section 73C. Exceptions apply for grants to Co-operative Research Centres. 92 Sections 73P to 73Z. 93 Sections 73H to 73M. 94 Companies with affiliates are “grouped”, and the group must have “group” expense and “group” turnover below the

thresholds.

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6.2 Concessions for PDFs and VCLPs

The R&D concession operates at the initial phase of research and development, prior to commercialisation activity. Conversely, the tax concessions for a Pooled Development Fund (PDF) or a Venture Capital Limited Partnership (VCLP) tend to operate after the commercialisation activity has reached the stage where the potential of the intellectual property has commenced being realised in the form of commercial profits. This is because the concessions operate by offering tax exemptions for the income and gains generated from the assets in question. 95

In brief, a PDF is taxed as a company on its profits, at concessional rates (15% on the venture capital component of investment and 25% on other profits). PDF dividends to shareholders are exempt from tax, or may, by election, be franked like normal company dividends. Capital gains made by shareholders on sale of their investment in the PDF are also exempt.

Under the VCLP regime, an exemption is provided to certain exempt foreign investors for capital gains made on realisation of eligible venture capital investments in Australian companies. The favourable outcome of tax exemption is achieved only when the investee company starts generating profits and the investment made by the VCLP increases in value, which is most likely to happen at the later stage of commercialisation activities. A concession is also provided for the manager’s remuneration in a VCLP, and flow through tax treatment is allowed for investors (although claiming of losses is limited).

We discuss these entities briefly here, as a point of comparison with the IP spin-off company, and highlight some of their advantages and disadvantages. It should also be noted that, in a Press Release of 10 May 2005, the Minister for Industry, Mr Ian Macfarlane MP announced a review of the venture capital concessions by a panel comprising government and private sector members.

6.2.1 PDFs96

More than 10 years ago, Australia introduced the PDF regime in the Pooled Development Funds Act 1992 with the goal of developing the market for “patient equity capital”, including venture capital, for small to medium-sized enterprises (SME’s). The regime was amended after a review in 1999 to make it more attractive for investors.

A PDF is a limited liability company and so it has the various commercial benefits that accrue to a limited liability company. It is also treated as a company for income tax purposes, but is eligible for a range of special tax concessions.97 However, to access these concessions, a PDF needs to act as an intermediary investment vehicle.

6.2.1.1 Special tax treatment of PDFs

A PDF is subject to a reduced tax rate on its taxable income, compared to an ordinary company. The assessable income of the PDF is divided into a venture capital or “SME” component, relating to investments in small and medium enterprises, and an other, “unregulated investment” component. Special rules apply for the ordering and allocation of tax deductions. Any capital gains of the PDF are also segregated into SME capital gains and “other” capital gains. 95 See also Ann O'Connell, "Using Tax Concessions to Encourage Investment in SMEs" (2000) 38 ABLR 443. 96 This section was prepared primarily by Miranda Stewart. See also Stewart, Venture Capital Taxation in Australian

and New Zealand” IPRIA Working Paper Series, Working Paper No. 02/05. 97 Most tax rules for PDFs are in Division 10E of Part III of the ITAA 1936 (ss 124ZM to 124ZZD).

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SME taxable income and gains of a PDF are taxed at a 15% rate. Any other “unregulated investment” taxable income and gains of a PDF are taxed at a 25% rate.

6.2.1.2 Special tax treatment of shareholders in PDFs

In addition to this lower tax rate for PDFs, shareholders of a PDF are eligible for concessional tax treatment. Dividends from a PDF may be franked just like other company dividends. Unless otherwise elected, a franked dividend is treated as exempt in the hands of most shareholders, with the result that the maximum tax rate on a PDF distribution is usually 15% and is not more than 25%.98

Alternatively, a shareholder may elect for taxation of the dividend, in which case the shareholder is entitled to a tax offset for the franking credit on a franked dividend, which can reduce tax on other income of the shareholder. The franking credit is calculated as if full company tax at 30% was paid, so that the value of the PDF concessional tax rate is actually flowed through to the shareholder and is not ‘recaptured’ at the stage of distribution of the profits. If this is done, an even lower tax rate may be achieved for some investors. For example, an Australian resident superannuation fund, taxed at 15%, will achieve an effective tax rate of only 7.5% on its PDF income that was invested in SMEs, through the use of franking credits to offset its other income.

A gain on the sale of a PDF share is exempt from tax (but a loss is, correspondingly, not deductible).99

If a PDF has invested in certain venture capital investments and has made capital gains, a special venture capital tax offset may apply to allow Australian resident superannuation funds and similar entities who invested in the PDF to receive those capital gains tax-free. The venture capital credit rules effectively enable the ‘flow through’ of venture capital gains tax-free for qualifying investors.100 To this extent, a PDF is analogous to a general partnership.

6.2.1.3 Treatment of start-up losses

Like an ordinary company, and in contrast to a general law partnership, a PDF is not able to ‘flow through’ start-up losses to its shareholders. The losses remain trapped inside the PDF entity. PDF losses may be carried forward, subject to the same majority ownership and business rules as for losses of ordinary companies. However, a PDF loss is only deductible in a later year if the entity remains qualified as a PDF.101 As for ordinary companies, where there are carried forward tax losses, a PDF may distribute a dividend to its shareholders, which will be unfranked (as no company tax is paid). Unlike ordinary companies, however, an unfranked distribution from a PDF is exempt in the hands of the shareholder.102 This means that if it is possible to carry forward a PDF loss, the value of that loss is not ‘recaptured’ at the stage of distribution of commercialisation proceeds but is ‘flowed through’ to the shareholders of the PDF.

6.2.1.4 Qualifications for PDF status

To be entitled to these tax concessions, a PDF must be registered with the PDF Registration Board (Ausindustry) and must provide annual returns to the Board. A PDF is subject to a range of investment, loan and governance restrictions. A PDF can invest in a small or medium enterprise company, with total assets of less than $50 million whose primary activities are not retail operations or 98 Section 124ZM(1B) of the ITAA 1936. 99 Section 124ZN of the ITAA 1936 and s 118-13 of the ITAA 1997. 100 Division 210 of the ITAA 1997. 101 Section 195-5 of the ITAA 1997. 102 Section 124ZM(1) of the ITAA 1936.

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property development, but cannot invest in another PDF. Normally, the PDF must invest at least 10% of the capital of the investee business through newly issued ordinary shares, and cannot invest more than 30% of the capital of the investee company, without special approval from the PDF Board.103

6.2.1.5 Limitations on use of PDFs in intellectual property commercialisation

It can be seen that a PDF is entitled to tax concessions which bring its tax treatment a significant way towards the general partnership tax treatment which is our ideal for an intellectual property commercialisation venture, while maintaining a separate legal entity. However, a PDF has a number of limitations for use as a spin-off company for intellectual property commercialisation.

Most importantly, the PDF must hold shares in other companies in order to attract the 15% tax rate; it is not itself a spin off company. The requirement to invest in shares also means that, while losses in a PDF will be treated more concessionally than losses in a spin-off company, the losses in investee SME companies remain trapped in those companies and will only attract concessional PDF treatment when the loss on that investment is realised. That is, the PDF will be able to pass on some of the benefit of flow through tax losses to its shareholders when it has sold a failed spin-off enterprise, but will not be able to pass on a loss resulting from start-up costs of an intellectual property commercialisation venture which it holds on to, and which may eventually be a success.

The PDF loss concessions may thus provide a useful incentive for PDFs to turn over “dead” or failed investments and move on to other options,104 but not to subsidise the start-up costs of an intellectual property commercialisation venture which may in the long run produce profits.

6.2.1.6 Experience in relation to PDFs

After a slow start, PDFs have proven reasonably attractive for some forms of venture capital investment. At June 2004, there were 109 active PDFs,105 while about half of the Australian venture capital investment vehicles in existence in 2004 were in the PDF program.106 PDFs had invested $630 million in Australian SMEs during the period 1992 to June 2004.107 As noted, however, a PDF has disadvantages, especially with regards to start-up losses, and is suitable primarily as an investment fund rather than an entity suitable for intellectual property commercialisation itself. There also appears to be a decline in the use of PDFs since 2001, when the number peaked at 126.

6.2.2 Venture Capital Limited Partnerships108

In 2002, the Federal Parliament enacted tax concessions for VCLPs that invest in or manage venture capital investments, and umbrella entities such as Australian Funds of Funds (AFOF) and Venture Capital Management Partnerships (VCMP), which manage or invest in VCLPs.109

103 For more detail on PDFs generally, and on these conditions specifically, see Steven Barkoczy, Don Moloney,

Wayne Ngo, Pooled Development Funds ATP 2001. 104 This is considered to be important generally in venture capital financing: see Gompers and Lerner, ibid. 105 PDF Board Annual Report 2003-2004, p.13-14. 106 ABS Venture Capital Statistics, ibid p.5. 107 PDF Board Annual Report 2003-2004, p.13-14. 108 This section was prepared by Miranda Stewart. 109 Section 94D(2) of the ITAA 1936.

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6.2.2.1 VCLP regime directed at foreign investors

VCLPs are taxed on a flow through basis, like general partnerships.110 The VCLP regime, like the PDF regime, has the goal of encouraging "patient venture capital" equity investment in Australian start-up businesses: Australians can invest in VCLPs; however, the VCLP regime is targeted particularly at foreign investors. The government considers that successfully attracting the necessary venture capital to commercialise R&D results in Australia will stimulate economic growth and job creation.111

The measures are intended to “facilitate non-resident investment in the Australian venture capital industry by providing incentives for increased investment which will support patient equity capital investments in relatively high-risk start-up and expanding businesses that would otherwise have difficulty in attracting investment through normal commercial means.”112

6.2.2.2 VCLP regime offers three tax reliefs

The VCLP regime provides three tax reliefs for investors:

(a) Gains from disposal of eligible venture capital investments made by VCLPs and AFOFs, or registered tax-exempt non-residents, are tax-free to the eligible non-resident partners and registered tax-exempt non-residents.113 That is, successful venture capital investments that generate a gain on sale will produce exempt gains for foreign exempt entities (such as pension funds).

(b) General partners of VCLPs and AFOFs and limited partners in VCMPs will enjoy capital gains tax treatment in respect of their shares of profits (carried interests) made by VCLPs, AFOFs or VCMPs.114 This means that they are eligible for the discount capital gains tax rate (50% discount for resident individuals). The benefit of that discount rate can be flowed through partnership and trust structures, so the VCLP manager may be an entity structured in that way, with individuals ultimately benefiting from the capital gains tax treatment. This concession effectively taxes the remuneration of a venture capital manager at a reduced rate.

(c) VCLPs, AFOFs and VCMPs are taxed as flow-though general law partnerships, although a special tax loss limitation rule also applies to them.115 This means that a loss generated on an eligible venture capital investment can be ‘flowed through’ to the limited (and general) partners in a VCLP or AFOF. The loss will likely be treated as capital in nature. It will not be relevant for foreign exempt investors, but will be able to be utilized by taxable Australian resident investors against capital gains from other sources.

110 Venture Capital Act 2002 (Cth), Taxation Laws Amendment (Venture Capital) Act 2002 (Cth). Minor amendments

were also made by Taxation Laws Amendment (Measure No 3) Act 2004, to ensure the venture capital regime operates as intended and to extend eligibility for the concession to investment in a holding company that meets the criteria.

111 Explanatory Memorandum to Taxation Laws Amendment (Venture Capital) Bill 2002 (Cth) and Venture Capital Bill 2002 (Cth) (Venture Capital EM), para 7.1.

112 Venture Capital EM, ibid General Outline, p.3. 113 Section 51-54 and Subdivision 118-F of ITAA 1997. 114 CGT event K9 in s 104-255 of ITAA 1997. 115 Section 94D(3) of ITAA 1936. The VCLP loss limitation rule is discussed in detail in M Stewart, “Venturing towards

flow through taxation of limited partnerships: it’s time to repeal Division 5A” (2003) 32 Australian Tax Review 171.

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6.2.2.3 Non-resident investors eligible for regime

Eligible venture capital partners and eligible venture capital investors include:

(a) Tax-exempt residents116 of Canada, France, Germany, Japan, UK and USA, who make eligible venture capital investments directly or through VCLPs and AFOFs, for example, superannuation funds, pension funds, endowment funds and foundations.117

(b) Foreign venture capital funds of funds118 which are established and managed in Canada, France, Germany, Japan, the United Kingdom, the United States and do not hold more than 30% of a VCLP’s or AFOF’s committed capital (as limited partners);119 and

(c) Taxable residents of Canada, Finland, France, Germany, Italy, Japan, the Netherlands (excluding Netherlands Antilles), New Zealand, Norway, Sweden, Taiwan, the United Kingdom and the United States who, as limited partners of VCLPs or AFOFs, hold less than 10% of the VCLP’s or AFOF’s committed capital.120

Australian residents can invest in VCLPs, but are not eligible for the capital gains tax exemption. If an Australian resident has an interest in a share of income of a trust, directly or indirectly, the trust will be disqualified to be an eligible venture capital partner.121 This exclusion is in line with the aim of the VCLP program to deliver tax benefits to overseas investors so as to attract foreign capital to Australia.

6.2.2.4 Registration requirements for regime

The Venture Capital Act 2002 provides administrative measures for operation of the tax relief and flow-through treatment of VCLPs.122 VCLPs and AFOFs must meet these administrative requirements and must register with the PDF Board, which monitors them by way of annual returns.123 The following table summarises the registration requirements in the Venture Capital Act:

VCLP AFOF Residence requirement

A limited partnership is established in Australia, Canada, France, Germany, Japan, UK or USA, and all its general partners are residents of a country above.124

A limited partnership is established in Australia according to the law of a State or Territory, and all general partners are Australian residents.

Period of existence The partnership is to remain in existence for at The partnership is to remain in existence for at least 5 years

116 An entity will not be a tax-exempt resident of the specified countries if it does not pay tax merely because of the

flow-through tax treatment, or the operation of a double tax treaty: Venture Capital EM, ibid paragraph 1.17. 117 Sections 108-405(1)(a), 108-410(1)(a) and (2)(a), 108-415, 108-420(1)(a) and (3) of ITAA 1997; see Venture

Capital EM, ibid paragraph 1.16. If these tax exempt non-residents invest through VCLPs or AFOFs, they can hold up to 100% of committed capital of the VCLPs and AFOFs: Venture Capital EM, para 1.10.

118 These could be limited partnerships, or entities which are not taxed as an entity in their countries of residence, but whose incomes is taxed to members in accordance with their interests in the entities: section 118-420(4) and (5) of the ITAA 1997.

119 Section 118-420(1)(b) and (4) of the ITAA 1997. The qualified foreign venture capital funds of funds are not necessarily established and managed in the same specified country: Venture Capital EM, ibid paragraph 1.20.

120 Section 118-420(6) of the ITAA 1997. 121 Section 118-420(7) of the ITAA 1997. 122 Section 3-1 of the Venture Capital Act. 123 Sections 118-405(2) and 118-410(3) of the ITAA 1997. 124 Every general partner of VCLP must be a resident of one of specified countries but not necessarily a resident of the

country in which the partnership was formed. See Para 2.7 of the Venture Capital EM, ibid..

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VCLP AFOF least 5 years but not more than 15 years. but not more than 20 years.

Committed capital125

At least $20 million N/A

125 A partnership’s committed capital is the total amount that all partners become obliged to contribute to the

partnership, including any amount to be contributed by way of debt: s 118-445 of the ITAA 1997.

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VCLP AFOF Investment requirement

(1) Eligible venture capital investments in an investee company; or (2) An investment in the investee company that would have been an eligible venture capital investment but for sections 118-425(2) and (6) (‘location within Australian’ and ‘permitted entity value’ requirements)

(1) Investment in a VCLP; (2) Eligible venture capital investment in a investee company in which the VCLP already holds an investment; or (3) An investment in the investee company that would have been an eligible venture capital investment but for sections 118-425(2) and (6) (‘location within Australian’ and ‘permitted entity value’ requirements)

Activities Only related to making Eligible Venture Capital Investments.

Only related to making Eligible Venture Capital Investments.

Debt interests Every debt interest that VCLP owns is a Permitted Loan.126

Every debt interest that AFOF owns is a Permitted Loan.

The VCLPs may be standard limited partnerships (under state law), or may be a new form of limited partnership, known as an incorporated limited partnership, that is a body corporate with legal personality separate from its partners.127 An incorporated limited partnership is included as a limited partnership for tax law purposes if it is formed solely for being registered as a VCLP or AFOF, or becoming a VCMP.128

6.2.2.5 Investment restrictions – investee must be a company

The VCLP is required to invest in companies which carry out the commercialisation activity. In this respect, VCLPs are similar to PDFs. The VCLP must not invest more than 30% of their committed capital in all the equity interests and debt interests that they own in an investee company and connected entities of that company.129 For a company to be eligible to receive capital from a VCLP, it must satisfy a number of requirements:

(a) Location within Australia: More than 50% of the people engaged by the investee company to perform services actually perform those services primarily in Australia and more than 50% of its assets are situated in Australia, for at least the first 12 months of the investment. At the time of the investment, the investee company must be an Australian resident.130

(b) An investee company must satisfy the ‘predominant activity test’, which requires it to satisfy at least two of the following requirements:131

(i) more than 75% of the company’s assets are used primarily in activities that are not “ineligible activities”;

(ii) more than 75% of the company’s employees are engaged primarily in activities that are not “ineligible activities”;

126 A permitted loan is a loan made by a VCLP or AFOF to an investee company. The loan must be repaid within 6

months unless the VCLP or AFOF holds eligible venture capital investment in the investee company which constitutes at least 10% of the equity interest and convertible debt interest of the investee company. Section 9-10 of the Venture Capital Act.

127 Section 84, Partnership Act 1958 (VIC). 128 Definition of ‘limited partnership’ in section 995-1 of the ITAA 1997. 129 Section 118-425(1)(d) of the ITAA 1997. 130 Section 118-425(2) of the ITAA 1997. 131 Section 118-425(3) of the ITAA 1997.

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(iii) more than 75% of the company’s total assessable income, exempt income and non-assessable non-exempt income come from activities that are not “ineligible activities”.

“Ineligible activities” are: property development or land ownership; finance activity by way of banking, providing capital to others, leasing, factoring or securitisation; insurance; construction or acquisition of infrastructure facilities; and making investments directed to deriving income in the nature of interest, rents, dividends, royalties or lease payments; and activities ancillary or incidental to the foregoing activities.132

An investee company is not allowed to invest any amount of money they received in another entity unless the entity is connected with133 the company and meets the other requirements (except ‘location within Australia’134).

(c) VCLPs and AFOFs can make non-eligible investments that meet the criteria of eligible venture capital investments except for ‘location within Australia’ and ‘permitted entity value’.135 No tax exemption is available for disposal of non-eligible investments and gains from disposal of these non-eligible investments will be taxable in the hands of partners of VCLPs and AFOFs (because of flow-through treatment). Nevertheless, a holding company which is a resident of Canada, France, Germany, Japan UK or USA will be an investee company and be qualified to receive eligible venture capital investments, provided that it meets ‘permitted entity value’ and ‘listing’ requirements, that it beneficially owns all the shares in an Australian resident company that satisfies the requirements for an eligible venture capital investment, and that it does not carry on any business other than to support the primary activity of the Australian company.136

(d) The value of the assets of the investee company and any connected entities must not exceed $250 million immediately before an investment is made: sections 118-425(6) and 118-440 (1).

Interestingly, the PDF Board has discretion to waive the ‘location within Australia’ requirement.137 An investee company could move more than 50% of its operation overseas after the first 12 months of the initial investment. Once an operation has commenced, this may be too costly, but this seems to support rather than discourage shifting high tech manufacturing and similar operations for commercialisation of Australian intellectual property offshore. Such a requirement may not effectively meet the ultimate aim of the VCLP reform, being to enhance investment in Australian commercialisation ventures, although it may lead to more efficient production in a global sense. It is not clear how significant this might be for VCLPs in the future, or how the PDF Board will monitor and enforce the policy of the program.

132 Subsection 118-425(13) of ITAA 1997. 133 The term ‘connected with’ is defined in s 152-30 of the ITAA 1997. 134 The legislation and Venture Capital EM appear ambiguous about this exception. Section 118-425(4)(a)(ii) requires

the entity to meet the requirements of “subsections (3) to (7)”, which do not include ‘location in Australia’, which is contained in s 118-425(2). However, the Venture Capital EM provides at para 3.18 that “unless the other entity …meets the residency, primary activities, size, [etc] … requirements”, it will not qualify. The EM thus appears to intend a ‘location in Australia’ requirement to be satisfied.

135 Sections 9-1(1)(e)(ii) and 9-5(1)(d)(iii) of the Venture Capital Act. 136 Section 118-435(1) of the ITAA 1997. 137 Sections 25-5 and 25-10 of the Venture Capital Act. Neither the Venture Capital Act nor the Venture Capital EM

specifies in what circumstances the Board may exercise such discretion.

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6.2.2.6 Treatment of gains and losses

Although the VCLP is a flow-though entity, start-up losses cannot effectively pass through to the VCLP partners, as they will be trapped in the spin off company in which the VCLP invests. Eligible venture capital partners and eligible venture capital investors will be entitled to an exemption from capital gains tax only on gains from disposal of investee companies’ shares or options which are owned at risk138 for at least 12 months, by VCLPs, AFOFs, or by registered tax-exempt residents of the specified countries directly.139 Any gains or profits made by eligible venture capital partners in VCLPs and AFOFs resulting from the disposal of the VCLP or AFOF interest are also exempt from income tax under s 51-54 of ITAA97. Correspondingly, a capital loss from the disposal is disregarded under subdivision 118-F and any other losses are not deductible under s 26-68 of ITAA97.

6.2.2.7 Limitations on use of VCLPs

At 30 June 2004, there were two VCLPs registered, and five conditionally registered or in process. At April 2005, seven VCLPs were apparently registered, with committed capital of $948.5 million, of which 12.1% was from overseas.140

As discussed earlier, there appear to be funding gaps in Australian intellectual property commercialisation (venture capital) investment that are preventing small, innovative business from obtaining sufficient capital and thus from producing public benefits in terms of innovation and job creation. In particular, funding gaps were found to arise for relatively small venture capital deals (e.g. under USD 5million). The permitted value of $250million for VCLPs widens intellectual property creators and venture capitalist investors’ choices and has certainly been welcomed by the venture capital industry. But it may not attract the venture capitalists investors to invest in seed and start-up capital for new spin off companies. As noted, although VCLPs provide flow through tax treatment to partners, as the only kind of eligible investment is in an Australian company, this does not assist in flowing through the costs (tax losses) that arise at the seed or start-up stages of investment. Similar problems arise as for the PDF structure. Also like the PDF structure, the VCLP tax concessions provide exemption of gains or profits and are thus geared towards a later stage of (already successful) investment.

There has not been enough time to evaluate the effectiveness of the VCLP tax exemptions in attracting foreign investors to invest in the Australian venture capital industry. However, it appears, at this early stage, that the VCLPs structures are attracting investment at the expansion or ‘buyout’ phases of venture capital investment, rather that at the seed or start-up phases.141 The new manager capital gains tax concession appears to be the most attractive feature of the VCLP structure. As it is linked to gains or profits made on a VCLP investment, it is attractive to managers seeking to make a large gain from the acquisition, re-engineering and sale of relatively mature venture capital investments.

138 For an investment to be at risk the VCLP, AFOF or the investor, must have no arrangement either before or after

the share or option is acquired as to maintaining the value of the share or option, or maintaining the amount of earnings made from owing it: section 118-430 of the ITAA 1997.

139 Sections 118-405(1)(d)(ii), 118-410(1)(f)(ii) and (1)(e)(ii), 118-415(1)(c)(ii), and 118-425(1)(a), (b) and (c) of the ITAA 1997.

140 PDF Board Annual Report 2003-2004, p.24-25; “First VCLPs raise capital mostly in Australia”, (2004) 141 Australian Venture Capital Journal 5

141 Telephone interview with Mr Kelvin Glossop, Assistant Manager, Venture Capital Programs, Ausindustry, 12 October 2004.

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6.3 Grant programs

As outlined above, Australia appears to have lower than optimal seed and start-up capital investment in intellectual property commercialisation. The Chief Scientist has identified a lack of “pre-seed” capital in Australia, to fund the earliest stages of intellectual property commercialisation, identifying a gap between early stage research and venture capital ready research.142 The Chief Scientist has also recommended a government “pre-seed” capitalisation fund to assist at this point.

While there is no general fund, the government has provided funding support to intellectual property commercialisation through a range of government grant programs,143 such as those which operate through Ausindustry. These are summarised in Appendix A to this report.

6.4 Relationship of special tax concessions to use of IP spin-off companies

This Chapter demonstrates the general limitations of Australian tax policy relevant to intellectual property commercialisation. Tax policy has focused on the earliest stage of intellectual property development, providing a subsidy for costs through the R&D concessions; and on the later stages of commercialisation when profits or value are being generated, by exemption or reduction of taxation on profits or on capital gains derived from successful investments. These existing tax incentives will tend to enhance the chances of successful intellectual property commercialisation. However, it is noteworthy that they do not directly target, and hence do not directly encourage, the activity of intellectual property commercialisation itself.

In particular the tax concessions do not operate directly on the type of intellectual property commercialisation activity with which a spin-off company is likely to be primarily concerned – the seed and start-up capitalisation stages, which operate to take the intellectual property from the initial phase, where it is merely an asset which is the outcome of a research and development effort with commercial potential, to the stage where its commercial potential has been realised by converting the intellectual property into a marketable asset capable of generating immediate commercial revenues.

Another noteworthy feature of the tax concessions is that they all require the use of a company as the relevant vehicle for the commercial activity associated with the development of the intellectual property. It is a condition of access to the benefit of the concessions that a company be adopted as the vehicle to hold, develop and commercialise the intellectual property.

One issue with which we are concerned in this Working Paper is the extent to which the existing intellectual property concessions are prevented from having their full beneficial effect as a result of inhibiting features of the income tax law. In particular, these concessions and grant programs will not be having their intended effect if other provisions of the income tax law tend to discourage or inhibit the use of companies for intellectual property commercialisation.

Accordingly, we suggest that the application of the income tax law to the formation of an IP spin-off company as the vehicle for commercialisation is a matter of importance. The parties to a potential intellectual property commercialisation venture between IP originators and venture capitalists may not adopt a spin-off company structure if that form of vehicle for intellectual property commercialisation

142 Chief Scientist, The Chance to Change, Final Report (November 2000) [7.4.4]. 143 Government grants made to a spin-off company to financially assist commercialisation activity will generally

constitute taxable income: see Reckitt & Colman Pty Ltd (1974) 4 ATR 501; First Provincial Building Society Ltd v FCT (1995) 56 FCR 320. They will also generally attract GST.

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has countervailing fiscal disadvantages. To avoid these disadvantages an alternative structure may have to be utilised, but which has greater governance costs, is less efficient from a commercialisation perspective and which is denied access to the R&D concession and other concessions. If appropriate outcomes cannot be obtained by another commercially acceptable vehicle, the intellectual property commercialisation activity may not proceed or the IP originators may find that fiscal considerations compel them to sell their intellectual property outright and abandon the concept of an economic venture altogether.144 For Australian originators of intellectual property, the alternative of selling intellectual property outright will often involve selling out to overseas venture capitalists and multinational enterprises. This may be regarded as a sub-optimal outcome from the perspective of the Australian economy.

This Working Paper therefore considers whether Australian income tax law has a tendency to produce sub-optimal outcomes by operating to discourage or inhibit the formation of spin-off companies to commercialise intellectual property in Australia.

144 Business Council of Australia, Removing Tax Barriers to International Growth (2001), p.96.

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Chapter 7 Alternative commercialisation vehicles and their general tax treatment

Intellectual property commercialisation activity is best conceptualised as an economic partnership between the participating entities. Suppose that a group of individuals, whose research and development efforts have originated some intellectual property (“the IP originators”) wish to enter into a commercialisation venture with a group of venture capitalists. The commercialisation of the intellectual property will require an economic partnership between the IP originators and the venture capitalists. The IP originators will need to contribute their intellectual property and ongoing research skills, and the venture capitalists will need to contribute their financial resources and ongoing business skills, to a common business enterprise conducted with a view to generating profit which will be shared between the participants. As economic partners, each participant would be expected to have an equity interest in the enterprise proportionate to the agreed value of their respective contributions.

There are, broadly, four legal vehicles by which such an economic partnership might be constituted: a limited liability company; a general law partnership; an unincorporated joint venture; or a trust. As will be discussed below, each has a different tax profile. Of importance also, are the different legal and commercial consequences which flow from adoption of any one of these alternatives. These issues are discussed in this Chapter.

7.1 Limited liability company

If a limited liability company is adopted, the general structure would be as follows:

(a) the IP originators would agree to contribute the intellectual property and their on-going research skills to the company;

(b) the venture capitalists would agree to contribute the finance, and their on-going business skills to the company;

(c) in exchange for the contributions, each participant would receive fully-paid shares in the company, the shares to be held in proportion to the agreed value of the respective contributions;

(d) the company would become legal owner of the intellectual property;

(e) in principle, the company would become legally responsible for the liabilities, debts and losses of the commercialisation activity;

(f) none of the shareholders would have legal liability for the liabilities, debts or losses of the commercialisation activity of the company;

(g) the shareholders would be entitled to share, in proportion to their shareholdings, by way of dividends and distributions of capital, in any net profit derived from the company’s commercialisation activity;

(h) the shareholders would share control of the company by appointment of directors to the board of the company.

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7.2 General law partnership

If a general law partnership is adopted, the general structure would be as follows:

(a) the IP originators would agree to contribute the intellectual property and their on-going research skills to the partnership;

(b) the venture capitalists would agree to contribute the finance, and their on-going business skills to the partnership;

(c) in exchange for the contributions, the participants would be regarded as partners holding equity interests in the partnership in proportion to the agreed value of the respective contributions;

(d) the partners would be treated as having beneficial ownership of the intellectual property as partners (in proportion to their equity interests in the partnership);

(e) the partners would be (as against third parties) jointly and severally liable for all the liabilities, debts and losses of the partnership’s commercialisation activity (but, as between themselves, severally liable in their equity proportions);

(f) the partners would be entitled to share, in proportion to their equity interests, in any net profit derived from the partnership’s commercialisation activity;

(g) as partners, they would share control of the partnership.

Example 1: Limited liability company

Assume the intellectual property contribution is valued at $7.5 million. The venture capitalists propose to contribute finance of $2.5 million. The intellectual property contributors may contribute their intellectual property to the company in exchange for 7.5 million shares in the company, and the venture capitalists might subscribe capital of $2.5 million for 2.5 million shares in the company.

Example 2: General law partnership

Assume the intellectual property contribution is valued at $7.5 million. The venture capitalists propose to contribute finance of $2.5 million. The intellectual property contributors may contribute their intellectual property in exchange for a 75% equity interest in the partnership, and the venture capitalists might subscribe capital of $2.5 million for a 25% equity interest in the partnership.

7.3 Unincorporated joint venture

An unincorporated joint venture is similar, but not identical, to a general law partnership. If an unincorporated joint venture is adopted, the general structure would be as follows:

(a) the IP originators would agree to contribute the intellectual property and their on-going research skills to the joint venture;

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Alternative commercialisation vehicles and their general tax treatment

(b) the venture capitalists would agree to contribute the finance, and their on-going business skills to the joint venture;

(c) in exchange for the contributions, the participants would be regarded as joint venturers holding an interest in the joint venture in proportion to the agreed value of the respective contributions;

(d) the joint venturers would each be treated as owning legally and beneficially a share of the intellectual property (in proportion to their joint venture interest);

(e) the joint venturers would be (as against third parties and each other) severally liable145 (not jointly liable) for a share, proportionate to their joint venture interest, of the liabilities, debts and losses of the commercialisation activity;

(f) the joint venturers would be treated as directly receiving their joint venture share of any income or gains, and as directly paying their joint venture share of any outgoings and expenses, of the commercialisation activity.

Example 3: Unincorporated joint venture

Assume the intellectual property contribution is valued at $7.5 million. The venture capitalists propose to contribute finance of $2.5 million. The intellectual property contributors may contribute their intellectual property in exchange for a 75% share in the joint venture, and the venture capitalists might subscribe capital of $2.5 million for a 25% share in the joint venture.

7.4 Unit trust

A unit trust has some similarities to a company with share capital. If a unit trust is adopted, the general structure would be as follows:

(a) the IP originators would agree to contribute the intellectual property and their on-going research skills to the trust;

(b) the venture capitalists would agree to contribute the finance, and their on-going business skills to the trust;

(c) in exchange for the contributions, each participant would receive fully-paid units in the trust, the units to be held in proportion to the agreed value of the respective contributions;

(d) the trustee of the unit trust would become legal owner of the intellectual property;

(e) in principle, the trustee would become legally responsible for the liabilities, debts and losses of the commercialisation activity;

(f) in principle, none of the unit holders would have legal liability for the liabilities, debts or losses of the commercialisation activity of the trust;146

145 One of the main commercial advantages of a joint venture over a partnership is that joint ventures involve (in

principle) several, rather than joint and several liability. 146 The principle of limited liability is, however, less certain with trusts than with companies.

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(g) the unit holders would be entitled to share in proportion to their unit holdings in any net profit derived from the trust’s commercialisation activity.

Example 4: Unit trust

Assume the intellectual property contribution is valued at $7.5 million. The venture capitalists propose to contribute finance of $2.5 million. The intellectual property contributors may contribute their intellectual property to the trust in exchange for 7.5 million units in the trust, and the venture capitalists might subscribe capital of $2.5 million for 2.5 million units in the trust.

7.5 Non-taxation considerations favour company over other commercialisation vehicles

There are a range of non-tax reasons why a company would be adopted for the purposes of giving effect to an economic commercialisation partnership, in preference to another form of entity.

7.5.1 Advantages of Company

The limited liability incorporated company is the normal vehicle for business activity in Australia. It offers the commercial benefit of limited liability to the proprietors of the business enterprise. It allows change of proprietorship without termination of the business enterprise: shareholders can simply transfer their shares. It enables the raising of additional equity (by issue of new shares) and debt capital for the enterprise. It has a perpetual life.

Because a corporation is recognised under Australian law as a separate legal entity, use of the company form facilitates the engagement of employees and the use of employee share arrangements. It likewise facilitates entry into legal relations with third parties on behalf of the enterprise.

It thus has the advantage of perpetual life, limited liability, the ability to change proprietorship without termination of the entity, and greater flexibility in raising new equity and debt, and entering contracts, on behalf of the enterprise itself.

A company is also attractive to foreign investors, in particular US investors, in venture capital-type operations. Foreign investors in Australia will tend to prefer to have their Australian activities in a company because of its separate legal personality, so as to segregate those activities from their business operations elsewhere for liability, accounting and other reasons. From a tax perspective, this may also ensure that the foreign investor is not found to have an Australian permanent establishment. A permanent establishment of a foreign investor potentially attracts Australian tax on a wider array of operations than an investment through an Australian subsidiary company. US tax-exempt investors, such as pension funds, may also be keen to segregate potential profit-making investments in a company so as to prevent the application of a special US tax on exempt organisations (Unrelated Business Income Tax).147

147 These and other reasons for preference of the corporate form by US venture capital investors are discussed (and

critiqued) in Daniel S Goldberg, “Choice of entity for a venture capital start-up: The myth of incorporation” (2002) 55 Tax Lawyer 923; Joseph Bankman, “The Structure of Silicon Valley Start-ups” (1994) 41 UCLA Law Review 1737; Victor Fleischer, “The Rational Exuberance of Structuring Venture Capital Start-ups” (2003) 57 Tax Law Review 137.

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7.5.2 General partnership compared to company

Another method of giving effect to a commercialisation partnership would be to form a general law partnership. Absent fiscal considerations, however, the general partnership is not the preferred vehicle for commercial or business activity in Australia.

A general law partnership has many disadvantages relative to a company. Primary among these is that it entails each partner having unlimited joint and several liability for the debts and liabilities of the enterprise. In the context of high risk commercialisation activity, unlimited joint and several liability is highly unattractive.

There are also other disadvantages. A change of proprietorship prima facie terminates the old partnership and creates a new partnership, so that the partnership terminates each time a new partner joins or an old partner leaves.

Partnerships are also cumbersome in terms of raising capital. It is not possible to raise new equity for a partnership from persons other than the partners, and it is difficult to raise additional debt capital for the enterprise without each partner becoming jointly and severally liable for the whole of that debt.

Because a partnership is not recognised under Australian law as a separate legal entity distinct from its owners, it is also more difficult to manage the engagement of employees and entry into legal relations with third parties on behalf of the enterprise. Employee shares cannot be used.

One advantage of a partnership, compared to a company, is that the latter requires incurrence of annual registration fees and other administrative expenses under the Corporations Act. But while it is possible for a partnership to be established at little cost, drafting an agreement for a partnership engaged in a complex intellectual property commercialisation venture will invariably be more costly than establishing a limited liability company.

7.5.3 Unincorporated joint venture compared to general partnership

Since a partnership has the commercial disadvantage of exposing each party to unlimited joint and several liability for the total debts and liabilities of the enterprise, the parties may prefer to adopt, as an alternative, an unincorporated joint venture structure to carry out the commercialisation. The commercial advantage of the unincorporated joint venture is that the parties have exposure to unlimited liability only in respect of their own share of the joint venture debts and liabilities, rather than joint and several liability.

It should be noted, however, that an unincorporated joint venture shares the other disadvantages of the partnership in terms of raising capital and lacks the commercial flexibility of a spin-off company in terms of bringing in new parties. Hence it is not to be preferred over the company form from a commercial perspective. Empirical evidence shows that it is not used by venture capital investors in any significant manner.148

7.5.4 Unit trust compared to company

As an alternative to a spin-off company, the parties could instead adopt a unit trust as a commercialisation structure. Australia is unusual, compared to other OECD jurisdictions (even 148 See National Survey of Research Commercialisation Years 2001 and 2002, ibid.

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common law jurisdictions), in the ability for commercial enterprises to adopt a trust structure for a business or commercialisation activity.

From a commercial perspective, a unit trust shares many of the advantages of a company. In particular, on the assumption that the trustee of the unit trust were a limited liability company, the unit trust structure should offer the unit holders limited liability protection and commercial flexibility which is approximately similar to that offered by the spin-off company form. Thus, the unit holders will have shareholder-like protection from liability in respect of the debts and liabilities of the commercialisation activity.

A unit trust also allows for a change of proprietorship without termination of the business enterprise, unit-holders can simply transfer their units. A unit trust also facilitates the raising of additional equity and debt capital for the enterprise. Additional equity capital can be raised by issuing new units. New debt capital can be raised by the trustee entering into borrowings.

Because the trustee corporation is recognised under Australian law as a separate legal entity, use of the unit trust form also facilitates the engagement of employees and entry into legal relations with third parties on behalf of the enterprise.

Hence, a trust would offer commercial outcomes similar to that of a company. That being said, however, there are limitations in the use of trusts. One is that, as a legal form for commercial enterprises, it is less common outside Australia and can lead to difficulties when dealing with overseas investors and financiers. It is also, within Australia, regarded as not subject to the same level of legal regulation as companies formed and regulated under the Corporations Act, which again can lead to some difficulties when dealing with investors and financiers. Another problem with the unit trust form concerns the operation of the R&D concession: in general, only companies can register for the R&D concession.

Also, where unit holders include tax-exempt institutions, the unit trust may be deemed a company for taxation purposes under Division 6C of Part III of the ITAA 1936.

7.5.5 Conclusion

In summary, it is difficult to think of any good policy reason which would support the income tax laws being drafted to as to inhibit or discourage use of a spin-off company as a vehicle for intellectual property commercialisation. The adoption of a corporate vehicle for intellectual property commercialisation, considered from the perspective of commercial, financial and economic efficiency, appears to be superior in all respects to the alternative of adopting a non-corporate vehicle such as a general law partnership, joint venture or trust.

7.6 General tax considerations favour unincorporated vehicles over a company

A rational income tax law might be expected to recognise that a spin-off company is the preferred form of vehicle for intellectual property commercialisation, and at least ensure that adoption of such a form does not lead to fiscal detriment or disadvantage as compared to adoption of a less efficient non-corporate form such as general law partnership, joint venture or trust. Unfortunately, Australian income tax law fails to meet this basic test of rationality. The general operation of the income tax law will in many cases produce unfavourable fiscal outcomes if a spin-off company structure is adopted; and these unfavourable outcomes will point instead towards adoption of a non-corporate vehicle, such as a partnership or unincorporated joint venture.

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The major taxation difficulties with use of companies, and the more favourable outcomes available if non-corporate vehicles are used, are discussed below. However, all the difficulties originate in the basic principle that Australian income tax law affords an income tax treatment to limited liability companies which is fundamentally different to that afforded general partnerships or joint ventures. The difficulties are compounded by the fact that, unlike the position in jurisdictions such as the United States, Australian tax law offers no mechanism for a small closely held company, which is for all practical purposes the economic equivalent of a partnership, to elect to be treated as a partnership rather than as a company for fiscal purposes.149 This may be an omission in need of reform.

7.6.1 Taxation treatment of company and partnership compared

The fundamental fiscal distinction between a corporation and a partnership is that the corporation is treated as a separate taxpaying entity, while the partnership is not.

7.6.1.1 Company traps start-up losses

A company is required to calculate its own taxable income for each financial year and pay tax at 30% if that taxable income is positive. The flat rate of 30% applies to revenue profits and capital gains. In the context of start-up companies, of special importance is the treatment of losses. Should the company make a net loss for a year, that net loss can only be carried forward and applied to reduce the taxable income of the company in future years. No deductible loss can be claimed by the shareholders in the corporation. In other words, start-up losses are trapped in the company.

7.6.1.2 Partnerships allow “flow-through” of start-up losses to partners

By contrast, the net income or net loss of a partnership is allocated directly to its partners for tax purposes.150 If the partnership has net income for a year, each partner pays tax on their share of the net income. If the partnership has a net loss, each partner can claim a tax deduction for their share of the net loss. The partnership is treated as a ‘flow-through” entity: the profits or losses flow directly through the entity to the partners. 151 Importantly, this means that start-up losses can flow through to the partners and be claimed as deductions against their other income.

7.6.1.3 Contribution of labour compared

Because a corporation is treated as a separate taxpaying entity, a contribution of labour to a company in exchange for shares is prima facie a taxable transaction for the contributing party at the time of the contribution: the shares are treated as income received for the labour.

By contrast, a contribution of labour by a partner to a partnership is not a taxable transaction at the time of contribution: the partner is not treated as receiving any taxable consideration for agreeing to be 149 For example, under the Internal Revenue Code of the United States (Title 26 of the US Code), small closely held

companies can be treated as Subchapter S corporations which are taxed like partnerships; and certain limited liability companies can by election be treated as partnerships under ‘check the box’ regulations. Such an elective mechanism for closely held businesses was recommended by the Asprey Review of the Australian Tax System, Final Report (1975) [16.79]-[16.96] but never implemented.

150 Division 5, ss 90-94 of the ITAA 1936. 151 Capital assets of a partnership are treated as being owned “fractionally” by the partners in proportion to their

interest in the partnership. This means that an individual partner may be eligible for the CGT 50% discount on capital gains arising from the disposal of a partnership asset, if the partner satisfies the relevant conditions; alternatively, a capital loss may be offset against other capital gains of the partner. See section 106-5 and Division 115 of the ITAA 1997.

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a partner, and as partner is only liable to tax on their share of any net income ultimately generated by the partnership.

7.6.1.4 Contribution of assets compared

Likewise, because a corporation is treated as a separate taxpaying entity, a contribution of assets to a company in exchange for shares is prima facie a taxable transaction for the contributing party at the time of the contribution: the shares are treated as consideration received for an outright sale of the entire interest in the assets.

By contrast, a contribution of assets by a partner to a partnership is only treated as a partial (fractional) sale, to the extent that other partners obtain a fractional share of the beneficial ownership of the assets. In addition, even this fractional sale may be disregarded for fiscal purposes under “rollover” concessions for partnership contributions applicable to various kinds of intellectual property assets. Specifically, for intellectual property in the form of depreciating assets such as copyright, patents, or designs, assets can be contributed to a partnership tax-free.152

7.6.1.5 Conclusion

These features of the general income tax treatment afforded partnerships in comparison to companies mean that, in practice, there are significant fiscal disincentives to the use of a commercially efficient company structure for commercialisation of intellectual property. In particular, the different treatment afforded a partnership has in relation to losses a tendency to instead favour the adoption of a fiscally efficient, but commercially inefficient partnership structure.

7.6.2 Importance of treatment of start-up losses

In deciding whether to commit funds to an investment activity, investors will take into account the present value of tax deductions associated with any losses incurred in the initial phases of the activity – typically referred to as start-up losses. The present value will be highest if the start-up losses can be deducted immediately against other income of the investors. The present value will be significantly diminished if deductions for start-up losses are effectively deferred until future years when the investment begins to generate positive returns.

Further, when the investment activity is inherently risky (as is the case with investment in intellectual property commercialisation) there will always be a significant risk that the activity will in fact never generate sufficient future income to enable deductions for the start-up losses to be realised. This will lead to investors further discounting the present value of the deductions for start-up losses.

7.6.2.1 Partnership maximises present value of start-up losses

Use of a partnership structure will therefore enable investors to place a higher present value on deductions for start-up losses than would be the case with the use of a company structure. This is because the partners will be able to immediately deduct the start-up losses against their own income from other sources - this is the all-important benefit of the “flow-through” of losses to partners in the case of a partnership.

152 See section 40-340(3) of ITAA 1997.

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7.6.2.2 Company diminishes present value of start-up losses

By contrast, where a company is used, it will not be possible to immediately deduct the start-up losses. Realisation of the losses will be deferred, unless and until the company itself can generate sufficient positive income from the commercialisation activity to enable the start-up losses to be deduction against that income. Further, because the losses are “trapped” within the company, and because the commercialisation activity is not guaranteed to produce positive returns, use of the losses is subject to the inherent risk that the company will never generate sufficient income to enable the losses to be used.

7.6.2.3 Additional tax problems with company losses

Tax law also adds two further problematic elements to usage of losses within the company structure. The first is the requirement that, for a company to “carry-forward” losses to deduct against income generated in future years, it must pass certain “loss-recoupment” tests. It must usually demonstrate that continuity of ownership of a majority of its share capital by the same persons has been maintained, from the start of the year in which the losses were incurred, to the end of the year in which they are finally deducted against other income (the “continuity of ownership test” (or COT)). Alternatively, if there has not been such continuity of ownership, it must be shown the company has at all relevant times continued to carry on the same business (the “same business test” (or SBT)). Plainly, there is a significant risk that an IP start-up company will fail these loss recoupment tests.

A second problem with tax law treatment of company losses concerns the position where a company does succeed in both meeting the loss recoupment tests, and generating sufficient commercialisation income to realise deductions for the start-up losses. The company will then have untaxed income – income free from company tax. If the company should wish to distribute that income to its shareholders as dividends, however, the shareholders will receive those distributions as “unfranked dividends”. This means they will be subject to full income tax as ordinary income in the hands of the shareholders. As a result, distribution of the income as dividends will effectively reverse the tax deduction for the start-up losses – the benefit of the loss deduction claimed in the company is reversed by the shareholders paying tax on their unfranked dividends.

7.6.3 Advantages of unincorporated joint venture compared to company and partnership

While a partnership offers superior tax treatment of start-up losses as compared to a company, as noted in 7.5.2 above, a general law partnership suffers from the serious commercial disadvantage that it exposes the partners to joint and several liability for the debts, losses and liabilities of the partnership.

As also noted above, an unincorporated joint venture may offer a better commercial position regarding liabilities. It should result in each joint venturer only having several liability for their individual share of debts, losses and liabilities. The question, then, is whether an unincorporated joint venture also offers the same favourable tax treatment for start-up losses that is enjoyed by a partnership.

The answer is that start-up losses do receive a similar (although not identical) favourable treatment in the case of an unincorporated joint venture. For taxation purposes, each member of the joint venture is treated as directly incurring their share of the joint venture deductible expenditure, and directly receiving their share of joint venture income. Accordingly, when the deducible expenditure for a year exceeds income for a year, the joint venturer will have excess deductions (a net loss, in effect) which they can deduct against income from other sources. As such, the start-up losses under an

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unincorporated joint venture flow-through in the same manner as a general partnership, and hence should have the same present value as under a general partnership.

7.6.4 Taxation treatment of unit trust compared to company and partnership

The treatment afforded companies and partnerships should also be compared to that afforded a unit trust. For income tax purposes, the unit trust is treated in part as a ‘flow-through’ entity, but only as to profits, not as to losses.153

7.6.4.1 Treatment of income

Where the trust income exceeds expenses for a year, the ‘net income’ of the unit trust for the year will be treated as flowing through the trust to the unit holders by direct attribution (even if it is not paid out to them by the trustee). The unit trust will not be liable to pay tax on the income; rather, the unit holders will be treated as the relevant taxpayers subject to tax on their share of the net income (or if foreign, the trustee will pay tax on their behalf, which is then credited to the foreign unit holder).154

Further, if the unit holder is a tax exempt institution, they will be exempt from tax on their share of the net income. This offers favourable taxation treatment of commercialisation income for tax exempt institutions similar to that offered by a general partnership or unincorporated joint venture.

7.6.4.2 Treatment of losses similar to company

However, the taxation treatment for a unit trust where the trust has ‘start-up losses’ is not as favourable as the treatment for a general partnership or unincorporated joint venture. This is because, for income tax purposes, the losses are treated as being made by the trustee and not by the unit holders, so the losses do not ‘flow through’ to the unit holders.

As is the case with the spin-off company, the losses will only be able to be used by the unit trust as a tax deduction against the future profits, if any, of the trust’s commercialisation activity. Furthermore, deduction of the start-up losses against future profits is by no means assured even if the future profits are in fact realised. Under the taxation rules concerning carry-forward of tax losses in trusts, tax losses from an early year can generally only be used against profits from a later year if there is satisfaction of various tests requiring continuity of majority ownership of the trust.155

7.6.4.3 Treatment of distributions superior to company

Hence, as with a spin-off company, if the unit trust has start-up losses, the best that can be hoped for is that the losses will be able to be used by the trust to reduce tax on future profits, if any, of the commercialisation activity. However, if it is possible to deduct the start-up losses against future profits, the income tax treatment of the trust is at that point again superior to the treatment of the spin-off company.

The start-up losses, in the case of the unit trust, will operate to shelter the profits from tax in the hands of both the trust and, when the profits are distributed to the unit holders, initially in their hands as well. By contrast, as noted above, in the case of the spin-off company, the start-up losses only shelter the profits from tax in the hands of the company; when they are distributed to the shareholders, the 153 Division 6 of Part III of the ITAA 1936. 154 Sections 97, 98 and 98A of the ITAA 1936. 155 The continuity tests apply under Schedule 2F of the ITAA 1936.

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distribution will be treated for income tax purposes as an unfranked dividend paid out of untaxed profits and subject to full taxation in the hands of the taxable shareholders.

The reason for the more favourable treatment of the unit trust is that the tax law only operates to impose a tax liability on the unit holders for their share of the net income of the trust; if the start-up losses reduce the net income of the trust to nil, or a negative amount, there is no net income for which the unit holders can have a tax liability.156 This will remain the case for the unit holders, even if the trust actually distributes the commercialisation proceeds to them as cash distributions in respect of their units.

The position, however, is not completely straight-forward: as distributions of cash from profits sheltered by start-up losses are made, the unit holders are treated as receiving a return of the capital they have invested in their units in the unit trust, and the cost base of the units for capitals gains tax purposes will be reduced.157 If the cash distributions exceed the cost base, the excess is eventually taxable as a capital gain. This would seem to be a generally appropriate outcome, since it would mean the start-up losses exceeded the actual capital invested by the unit holder. The capital gain may be taxed at a discounted rate (50% of the usual rate) for eligible Australian resident individual unit holders.

Thus, the unit trust structure has the advantage of operating so that the effective rate of income tax on the ultimate proceeds of commercialisation should be lower than the effective rate which would apply were the spin-off company form adopted.

7.6.4.4 Trust similar to company in other respects

The unit trust structure does not, however, offer a solution to some of the other problems which apply to the spin-off company form. In particular, the contribution of intellectual property to the unit trust in exchange for units will realise tax liabilities at the time of contribution in the same way as a contribution to a company in exchange for shares. Likewise, a contribution of labour in exchange for units will raise the same taxation problems as arise with employee share arrangements.

7.6.4.5 Other problems with trusts

If the intellectual property commercialisation unit trust is, or will become, widely held or listed, it may in any event be deemed to be a company for tax purposes and so taxed in a similar manner to limited liability companies.158

Moreover, where the parties to the commercialisation venture include tax-exempt institutions, there is a risk that the unit trust will be deemed to be taxable as a company under special anti-avoidance rules which apply where tax-exempt entities hold or control not less than 20% of the units159.

Another problem with the unit trust form concerns the operation of the R&D concession: in general, only companies can register for the R&D concession.

156 Section 95 of the ITAA 1936. 157 Sections 104- 70 and 104-71 of the ITAA 1997. 158 Division 6C of Part III of the ITAA 1936 159 Division 6C of Part III of the ITAA 1936, especially section 102P(2).

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7.6.4.6 Unit trusts a superior vehicle to company

In summary, the unit trust is an attractive vehicle in some respects for spin off commercialisation of intellectual property. It offers similar commercial outcomes to a company, but superior tax outcomes in various aspects. ABS statistics indicate that a significant percentage of venture capital investment is taking place through unit trust structures. However, it seems likely that many of these “funds” are actually investing in PDFs (discussed in Chapter 6 above), or are otherwise operating as general investment funds that hold shares in spin off companies, rather than themselves being the entity for the spin off operation. In an ABS Research Report, Venture Capital Australia (ABS 5678.0, 26 November 2004), it is reported that, at June 2004, 43% of venture capital investments were made through unit trust funds, which then invested in companies.

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Chapter 8 Problems in the contribution of intellectual property assets to a spin-off company

As identified in Chapter 7, one of the taxation problems with adoption of an IP spin-off company as the commercialisation vehicle is that tax liabilities can arise on contribution of the intellectual property assets to the company. This Chapter considers that issue in more detail. It assumes, as in Chapter 7, that there is a formation of a commercial vehicle by IP originators and venture capitalists.

8.1 Taxation of future unrealised gains on formation of commercialisation vehicle

The contribution of the intellectual property to the commercialisation vehicle by the IP originators is conceptually a contribution of assets to an economic partnership. No economic gain is realised by the IP originators at this time – they have merely agreed to combine their intellectual property with the financial resources of the venture capitalists with a view to generating future economic gains. Moreover, the prospect of the future economic gains being generated will, in most cases, be highly contingent – commercialisation of intellectual property generated by research and development is a high risk entrepreneurial activity.

This being so, under a rational income tax law the contribution of the intellectual property to the commercialisation vehicle should not result in the immediate realisation of taxable gains to the intellectual property contributors. At the time of formation of the vehicle, the market value of the intellectual property will merely represent the present value of its potential to generate future income. If that potential should ever be realised, and the income should in fact be generated, it will be taxed at that time as ordinary business income. To tax the value of the intellectual property at contribution constitutes taxation of unrealised future income. Further, it can also be seen that, if the present value of the potential future income is taxed at formation, and the actual income is also taxed if and when subsequently realised, there will be double economic taxation of the same income.

8.2 Position if spin-off company used as commercialisation vehicle

The position under current Australian income tax law is that if the participants use the spin-off company structure to commercialise the intellectual property, the contribution of the intellectual property to the spin-off company in exchange for shares will generally realise taxable gains for the IP originators.160 This irrational outcome arises because the income tax law sees the contribution of the intellectual property as a sale of a 100% interest in the intellectual property to the company as a separate entity, in exchange for a consideration equal to the market value of the shares. The intellectual property contributors are thus taxed as if they have disposed of their entire interest in the intellectual property, notwithstanding that they have in fact retained a substantial economic interest.

This will often result in income tax being levied on close to 100% of the market value of the intellectual property at the time of its initial contribution. Since the value of the shares issued as consideration will equate to the market value of the intellectual property, the consideration will be valued at the market value of the intellectual property.161 The taxable gain will be calculated as the 160 Section 104-10 (CGT event A1) or 104-35 (CGT event D1) of the ITAA 1997. 161 Division 116 of the ITAA 1997.

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consideration so valued, less the tax cost base of the intellectual property. The tax cost base of the intellectual property generated by a group or individual researchers will typically be low, and will often be nominal because it does not include the value of unpaid labour; nor does it include the value of money or property expenditure for which a tax deduction has previously been claimed.

Such an outcome is contrary to the general position in other countries, including the US (as discussed in Appendix B).162

Example 5 – Contribution of intellectual property Assets to spin-off company

As in Example 1, Chapter 7, assume the spin-off company was formed on terms which valued the intellectual property contribution at 75% of the total value, so that the intellectual property contributors received 75% of the shares in the spin-off company and the venture capitalists 25%. They would have retained a 75% economic interest in the intellectual property and parted with only a 25% economic interest. Nonetheless, they would be taxed as if they had disposed of a 100% interest. The difference is of considerable practical importance. If the intellectual property contribution has a market value of $7.5 million, the intellectual property contributors would be taxed as if they had sold their entire intellectual property for $7.5 million, notwithstanding that the actual 25% economic interest with which they have parted has a true value of only $1.875 million.

8.3 Rollover concessions limited

It is true that the income tax law offers certain ‘concessions’ on contribution of assets to companies, which may partly mitigate these outcomes, but they only operate in limited circumstances and can hardly be regarded as a systematic solution to the problem. Three concessions may be mentioned.

(a) Contribution to wholly-owned company: If the intellectual property is owned by a single individual, and the intellectual property is contributed to a company in which the individual owns all the shares, ‘rollover relief’ can be claimed on the contribution.163 This rollover relief will have limited operation in practice, however, since intellectual property is typically generated by groups of individuals rather than a single individual, and the spin-off company will not be wholly-owned by a single individual. Where intellectual property has been generated by a general law partnership, a rollover is available if the partners contribute the intellectual property to a company164 (this is another advantage of commencing with a partnership); but this would require that IP originators to have formed a partnership before commencing any activity.

(b) Tax exempt parties: If the intellectual property is owned by a tax exempt public research institution such as a public university, no tax liability will arise on the intellectual property contribution by reason of the tax exempt status of the contributor. This eliminates one of the tax problems associated with the spin-off company. However, it may be noted that the trend in public research institutions is to allow individual research workers intellectual property rights over the product of their research work.165

162 Studies on International Fiscal Law, Volume LXXXIIa, “The taxation of income derived from the supply of

technology” (IFA, 1997), p.45. 163 A contribution of assets by a single individual to a wholly-owned company attracts a rollover under section 40-340(1)

(item1), for depreciating assets, and Subdivision 122-A, of the ITAA 1997 for capital assets. 164 Subdivision 122-B of ITAA 1997. 165 See Commercialisation of University Research,ibid p.31; National Innovation Summit Working Group, Managing

Intellectual Property - Framework Paper (Dec 1999), p.38.

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Problems in the contribution of intellectual property assets to a spin-off company

(c) Confidential information: Under current income tax law and practice, intellectual property which takes the form of confidential information or trade secrets is generally not regarded as a taxable asset. Hence, a contribution of valuable confidential information or trade secrets to a spin-off company in exchange for shares may escape taxation.

The position in (c) above with respect to confidential information and trade secrets is, however, somewhat complex. Copyright, patents, and registered designs are regarded as depreciating assets and so a contribution of copyright, patents, or registered designs in exchange for shares in a spin-off company would realise taxable gains, if a rollover relief could not be claimed. On the other hand, confidential information and trade secrets are regarded neither as depreciating assets nor assets for capital gains tax purposes, so a contribution of such intellectual property by way of an outright disposal and surrender of all interest in the information, in exchange for shares, prima facie should not realise a taxable gain.

Nevertheless, a contribution of confidential information and trade secrets may still result in taxable gains if the dealing itself is not an outright disposal, and results in the creation or disposal of separate valuable contractual or property rights which relate to the intellectual property. For example, the creation of an exclusive licence to use trade secrets in exchange for shares in a spin-off company may be seen to be a transaction by which valuable contractual rights are created in exchange for taxable consideration. Alternatively, a contribution of confidential information or trade secrets might be treated as a contribution of services or labour, which would also generate taxable income (see 4.4.2 above).

In any event, the distinction between the fiscal treatments afforded on the one hand, copyright, patents, and registered designs, and, on the other hand, confidential information and trade secrets, can hardly be regarded as having any rational basis in income tax policy. Indeed, it may have the irrational effect of discouraging IP originators from protecting valuable confidential information under the laws of copyright, patents or designs.

8.4 Interaction with R&D concession

Further, on the contribution of intellectual property assets to a spin-off company, the interaction with the R&D concession would need to be considered.

If the contributor was a company, in that case, the share consideration for the confidential information and trade secrets would prima facie be taxable if the intellectual property had been the subject of expenditure for which deductions under the R&D concession had been claimed.166 However, where the intellectual property was generated by individuals or a tax-exempt research institution, the R&D concession is unlikely to be in issue.

8.5 Position if general partnership used as commercialisation vehicle

The fiscal outcomes on the contribution of intellectual property to a spin-off company may be compared to the position if the parties were to contribute the intellectual property assets to a general law partnership as the vehicle for the commercialisation enterprise.

166 See Chapter 6, at 6.1.8.

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The income tax law contains a specific tax relief which applies where there is a contribution of depreciating assets to a general law partnership.167 Under this relief, the partners can elect that no taxable gain should arise on the contribution of copyright, patents, or registered designs to a general law partnership. Further, since confidential information and trade secrets are regarded neither as depreciating assets nor assets for capital gains tax purposes, no taxable gain should arise on a simple contribution of such intellectual property to a general law partnership. Hence, it would be possible to adopt a general law partnership structure without realising significant taxable gains on the contribution of the intellectual property.

8.6 Scrip-for-scrip rollover

The specific rollover available in the case of a contribution of intellectual property assets to a general law partnership reflects the fact that the contributing partners do not realise economic gains on the contribution. There is no difference in economic substance between this case and the case of a contribution to a spin-off company. It is irrational for the tax law to draw a difference in treatment.

The lack of rationality in this outcome is emphasised by the fact that the income tax law has recently been amended to allow tax relief where the owners of two companies choose to combine their companies under a common company. The tax relief, referred to as the ‘scrip for scrip’ rollover,168 would permit the shareholders of two separate companies to contribute their respective shares in the two companies to a third new company, in exchange for shares in the new third company, and claim a full relief from tax liability on the contribution. The Review of Business Taxation was of the view that, without such relief, the efficient combination of businesses through merger and acquisition activity was being impeded by tax costs.169 The same reasoning supports the need for tax relief on the contribution of assets to a spin-off company formed to commercialise intellectual property.

The “scrip for scrip” roll-over means parties to formation of an IP spin-off company might attempt to use “self-help” in the form of tax-planning to avoid initial taxation costs in adopting a corporate structure. They could, possibly, bring themselves within the combined operation of the “contribution to wholly-owned company” and “scrip for scrip” rollover relief as follows:

(a) each individual intellectual property originator could first contribute their individual interest in the intellectual property to a company wholly-owned by each individual; this attracts a tax roll-over (as discussed at 8.3(a) above); and

(b) then, the parties could merge each individual company under a new company, and claim the scrip for scrip rollover.

This would, however, be complex, expensive, and potentially subject to the Tax Commissioner’s powers to invoke anti-avoidance rules.

8.7 Use of “modified” unincorporated joint venture structure

Alternatively, the parties may use “self help” to avoid initial taxation costs by adopting a modified form of an unincorporated joint venture structure.

167 Section 40-340(3) of the ITAA 1997. 168 Subdivision 124-M of the ITAA 1997. 169 Review of Business Taxation, A Tax System Redesigned, Recommendation 19.3.

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Under this “modified” joint venture:

(a) the IP originators agree to make the intellectual property available to the joint venture under a bare licence; and

(b) the venture capitalists agree to make loans to fund certain expenditures.

The intent of this licence/loan arrangement is to defer any outright disposals of property interests in the intellectual property until future commercialisation proceeds emerge. Such structures are, however, complex, commercially inflexible and unlikely to be durable.

Example 6 – Modified Unincorporated Joint Venture

IP ORIGINATORS

Licence of IP †

VENTURE CAPITALISTS

A particular commercial problem with such a “modified” joint venture is to determine who should own any “new” intellectual property generated from the use of the licensed “old” intellectual property.

8.8 Position if unit trust used as commercialisation vehicle

The unit trust structure does not offer a solution to the problems faced by a company here. The contribution of intellectual property to the unit trust in exchange for units will realise tax liabilities at the time of contribution, in the same way as a contribution to a company in exchange for shares.

8.9 US position compared

As discussed in Appendix B, the US tax law appears to offer broader tax relief on the contribution of intellectual property assets to a spin-off company. This means US tax law does not contain the same obstacles to use of a commercially efficient vehicle for the commercialisation activity.

Loan of capital ¥

JOINT VENTURE §

† IP originators licence all parties to the joint venture to use the intellectual property assets for the purposes of the

commercialisation venture. ¥ Venture capitalists agree to advance funds to meet expenses of the commercialisation venture § Parties to venture share in product of commercialisation venture.

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8.10 Conclusion

The absence of general tax relief on the contribution of intellectual property to a spin-off company has the inevitable tendency to force the parties to choose between facing an upfront tax cost, or adopting sub-optimal commercialisation structures, such as a general law partnership or some other informal structure. This is, therefore, a clear case of the tax law operating to inhibit efficient commercialisation of intellectual property.

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Chapter 9 Does the income tax system discourage employee share ownership in intellectual property spin-off companies?

170

In a report, “Developing High Technology Enterprises for Australia”, prepared by the High Technology Financing Committee of the Australian Academy of Technological Sciences for the Minister of Science and Technology in April 1983, it was stated:

The use of stock options is integral to the formation of management teams for young high technology enterprises in the USA, UK and Canada. The Committee recommends that the Government consider the benefits of more favourable taxation treatment of stock options to help attract skilled management to small and medium sized high technology enterprises.

Despite more than 20 years having elapsed since that report, we still find that tax law lacks a favourable treatment of employee share ownership arrangements in technology enterprises. As identified in Chapter 7, use of employee shares in an IP spin-off company as an alternative to cash salary still presents taxation problems. This Chapter looks in more detail at the taxation issues associated with shares and options.

9.1 Importance of employee shares to IP spin-off companies

In its early phases of operation a spin-off company will typically face significant cash-flow constraints. It is a common-place method of operation for the individuals associated with the commercialisation activity of the spin-off to agree to provide their labour in exchange for shares in the spin-off company, rather than for a normal cash salary or wage.

These arrangements are typically referred to as ‘employee share arrangements’, since the individuals will usually (although not always171) be regarded as employees of the company from the perspective of their formal legal position. This formal label does, however, obscure the true economic nature of the relationship. In substance, the individuals are partners in the economic partnership constituted by the spin-off company. They agree, like partners, to contribute their labour to an enterprise in exchange for an equity share in the profits of the enterprise. The value of the labour contributed is the equivalent of an ‘at risk’ investment in the enterprise. The economic relationship is far removed from the traditional salaried employee who receives a guaranteed and fixed cash salary regardless of the economic fortunes of the enterprise.

It is difficult to think of any policy rationale for the income tax law to operate so as to discourage such arrangements. The spin-off company will typically lack the cash-flow to provide a normal cash salary or wage, so the arrangement cannot be characterised as having tax avoidance aspects. On the contrary, given the cash-flow constraints, the arrangement is commercially efficient, and in many cases commercially essential. It also has the added advantage of giving the individuals an equity interest in the outcome of the activity, and hence an increased incentive to remain with the company until it reaches the stage of a successful commercialisation.172

170 This Chapter was prepared primarily by Ann O’Connell and Cameron Rider (See also Rider, Sellers of labour or

investors of intellectual capital? (IPRIA Working Paper – forthcoming)). 171 For example, the individuals might agree to supply services as independent contractors. 172 Such remuneration arrangements have been recommended in Unlocking the Future, ibid p.25.

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9.2 Income tax law generally discourages use of employee shares: taxation of unrealised future gains

However, the income tax law again takes an irrational approach. Because the spin-off company is, from a formal legal perspective, the employer of the individuals who have agreed to contribute their labour, the income tax law will treat the shares received in the spin-off company as in the nature of employment income equivalent to a cash salary. Indeed, to ensure that income tax will generally be levied on the market value of the shares received, at the time they are received, specific provisions have been enacted – Division 13A of Part III of the ITAA1936, which is discussed below.173

Where shares or rights are provided to an employee in respect of employment (or to an associate of the employee) without payment in money or property of at least equal market value – in short, if the shares are issued ‘at a discount to market value’ - an amount equal to the discount (the “acquisition discount”) will generally be included in the assessable income of the employee and taxed at ordinary income tax rates. The shares will be treated as provided at a discount to the extent that the employee does not pay money or provide property for the shares – the provision of labour will not be treated as market value payment.

This also applies in a non-employment situation where shares or rights are provided in respect of services rendered.

This treatment arises, notwithstanding that those contributing the labour would not have derived any realised income or gain from the shares at the time the shares are first issued. As already noted, the market value of the shares at this time will merely represent the present value of the intellectual property’s potential to generate future income. Further, if and when that future income is actually generated, it will be taxable at that time in the hands of the spin-off company and, if distributed as dividends on the shares, taxable again in the hands of the employees as shareholders. The law is again seen to produce taxation of unrealised potential future income; and, if that potential is realised, income will also be imposed on the actual realised income: hence there is double economic taxation of the same income.

9.3 Limited concessions do not assist IP spin-off companies

The tax law does offer certain ‘concessions’ which are intended to partly mitigate these outcomes for certain kinds of ‘qualifying employee share plans’. But the conditions and limitations of these concessions mean they are unlikely to provide any systematic relief in the context of intellectual property commercialisation through a spin-off company.

There are, broadly, two types of concession:

(a) Exemption concession: an exemption from tax of up to $1,000 worth of ‘acquisition discount’ per annum.

(b) Deferral concession: an election to be taxed on the value of the shares on a deferred basis, provided the shares are issued on terms which prevent the employee being able to dispose of them unless and until certain conditions are satisfied (the tax liability being deferred until the

173 Division 13 A of Part III of the ITAA 1936. Such tax treatment has been criticised by W. D. Ferris AO in

“Australia Chooses: Venture Capital and a Future Australia” at p.61: “The founder managers of the companies, be they university scientists or budding young entrepreneurs, are expected to find the cash to pay the tax on the paper value of their options upfront. What a naïve and ignorant expectation.”

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Does the income tax system discourage employee share ownership in intellectual property spin-off companies?

time at which the conditions are satisfied, but imposed on any increase in market value since the acquisition date).

The exemption concession is unlikely to cover the value of the labour contributed in lieu of a normal annual salary, and so can be disregarded for present purposes.

The deferral concession prima facie appears to have potential to offer relief, but closer examination reveals that the various conditions which must be met mean this concession is better suited to the circumstances of a grant of executive options in a successful stock exchange listed public company, than the circumstances of an IP spin-off company looking to give shares instead of cash salary in the start-up phase of its operations.

9.4 Division 13A

The relevant provisions concerning employee shares and options are in Division 13A, Part III ITAA 1936 (Division 13A). They apply when shares, or rights to shares, are issued in respect of employment. The amount to be included in assessable income or such shares or rights is basically the difference between the market value of the share or right and any money or property consideration provided, that is, the amount of the discount provided to the employee (the “acquisition discount”). Rules are provided for calculating the market value of the share or right.

Division 13A also provides for concessional treatment provided certain conditions are satisfied, as noted above. The first type of concession allows for discounts of up to $1000 to be provided tax free to an employee or service provider per income year (the exemption concession). The second type of concession allows for tax on the discount to be deferred for up to 10 years (the deferral concession). Critics argue that the exemption concession provides insignificant benefits, while the conditions for both concessions are difficult to satisfy.

9.4.1 Policy of Division 13A

The broad policy behind Division 13A is to encourage employee share ownership while at the same time trying to guard against exploitation of the concessions available to unduly minimise taxation. In this regard, a House of Representatives Committee established to consider various aspects of what are commonly described as “employee share schemes” noted that, in practice, there are really two rationales for the use of such schemes – one being to encourage share ownership by employees (general schemes) and the other being to facilitate tax-effective remuneration arrangements for corporate executives (executive schemes).174 It was also noted that general schemes are more likely to access the exemption concession while executive schemes are more likely to access the deferral concession.175

The Committee also noted that those companies most likely to provide such schemes and therefore access the concessions are listed companies rather than SMEs or “sunrise enterprises”.176 Indeed, the

174 House of Representatives Standing Committee on Employment, Education and Workplace Relations Report,

“Shared Endeavours – An inquiry into employee share ownership in Australia”, September 2000. p.10. 175 Ibid pp.129-130. 176 Ibid p.53. The term “sunrise enterprise” is defined in the Report as “a company that operates in a sunrise industry,

is small or medium in size, typically less than 5 years old and is speculative, knowledge intensive and/or relying on venture capital”. A “sunrise industry” is typically “knowledge intensive, in an emerging area of the economy and is commercialising recently developed technology and/or research and development outcomes” (p.xxiii).

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Committee was sufficiently concerned about the difficulties faced by “sunrise enterprises” to recommend that they be given a number of special concessions to enable them to develop employee ownership. However, the government has rejected these recommendations.

9.4.2 Different types of employee share plans

There are a number of different plans or arrangements which potentially fall within Division 13A. They include:

(a) the provision of shares or rights (the latter sometimes referred to as option plans);

(b) the provision of shares or rights accompanied by a low interest or interest-free loan;

(c) the provision of shares or rights through an employee share trust; and

(d) the provision of rights that are not within Division 13A.

The tax treatment of the different types of plans needs to be considered.

9.5 Division 13A and the provision of shares or rights

In the basic type of share plan an employer will provide shares at a discount to employees. The employee may be required to pay the full discount price for shares (the shares are “fully paid”) or may only have to pay a small amount of it (the shares are “partly paid”). In the latter case the employee will not usually be required to pay any calls on the shares, if at all, until disposal.

Alternatively, an employer may provide options to acquire shares. The option is usually issued for no consideration with a right to acquire shares at a nominated price (the exercise price) in the future. The exercise price is usually the market price of the shares at the time the option is granted.

Unless concessions are available, the effect of Division 13A is to include an amount in assessable income at the time the shares or rights are acquired.177

The Division applies if any shares or rights (see below) are acquired under an “employee share scheme”. Shares or rights are acquired under an employee share scheme if the shares or rights are acquired in respect of, directly or indirectly, employment or services rendered (see below). The shares or rights may be acquired by an employee or a service provider or by an associate of the employee or service provider (se below). The Division contains rules for determining the amount to be included in assessable income (see below). The remainder of this section deals with the available concessions and other relevant taxing provision.

9.5.1 Any shares of rights

The Division applies when an employee or service provider acquires any shares or rights under an employee share scheme, whether they are shares or rights in the employer company, a related company or any unrelated company. However, in order to obtain access to the concessions it is

177 Section 139B ITAA 1936.

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necessary for the shares or rights to be in the employer company or a holding company of the employer.178

The term “rights” is not defined but is commonly taken to mean rights to acquire shares, ie options. An option involves the right, but not the obligation, to acquire shares in the future at a fixed price (the exercise price). In some cases the person acquiring the option pays to acquire that right but commonly in the employment case the option is acquired for no consideration. The term “rights” could also encompass other sorts of rights such as those rights that replicate shares eg “phantom shares” (see below). However, in order to access the concessions, the rights must be rights to acquire ordinary shares.179

The acquisition of a share as a result of exercising a right acquired under an employee share scheme is not treated as the acquisition of a share (to avoid double counting).180

A point to note is that the shares or rights must be acquired at a discount (the “acquisition discount”). The acquisition of shares for a consideration equal to or greater than market value will not be within the Division even if accompanied by some other benefit such as a low or interest-free loan to fund the acquisition.

9.5.2 Acquired under an employee share scheme

Shares or rights will be acquired under an employee share scheme if they are acquired directly or indirectly in respect of employment.181 They are also deemed acquired under an employee share plan, even if the parties are not in an employment relationship, if the shares or rights are issued in respect of services rendered.182 That is, there does not need to be any particular form of scheme but rather there must be some connection between the acquisition of the shares and the employment or services provided. If the acquisition falls within Division 13A it will be taxed under that Division rather than the other provisions of the income tax legislation. Furthermore, the acquisition will not give rise to fringe benefits tax.

Shares will not be taken to be provided under an employee share scheme (and therefore not subject to Division 13A) if they are acquired for market value183 - ie if there is no “acquisition discount” (see below).

9.5.3 Acquired by an employee or service provider (or an associate)

A person acquires a share when it is transferred or allotted to that person or when a person acquires a legal or beneficial interest in the share from another person.184 Division 13A applies to both employees and independent contractors acquiring shares.185 Division 13A also applies if an associate of the employee or service provider acquires shares as a result of the employment or provision of services.186 An associate in this context includes a relative, a partner, a trustee of a trust under which 178 Section 139CD(3) ITAA 1936. 179 Section 139CD(4) ITAA 1936. 180 Section 139C(4) ITAA 1936. 181 Section 139C(1) ITAA 1936. 182 Section 139C(2) ITAA 1936. 183 Section 139C(3) ITAA 1936. 184 Section 139G ITAA 1936. 185 Section 139C(1) and (2) ITAA 1936. 186 Ibid.

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the taxpayer or an associate is capable of benefiting187 and related companies.188 In such a case the employee or service provider will be subject to tax on the acquisition discount received by the associate.189 Although shares or rights provided to an associate will be subject to tax under Division 13A, only shares or rights provided to an employee will be eligible for the concessions.190

9.5.4 Calculating the amount to be included in assessable income

The rules for determining the amount to be included in assessable income vary according to whether the discount is assessable immediately or is deferred.

When the discount is included in assessable income in the year the share or right is acquired, the amount is the market value of the share or right less any consideration paid or given.191

When the taxing time is able to be deferred under the “deferral concession” to a future time (the cessation time), and the taxpayer disposes of the share or right within 30 days of the relevant “cessation time” in an arm’s length transaction, the amount to be included (at that time) is the amount received on disposal, less any consideration given, including any amount paid to exercise a right to acquire a share.192

In other words, if the deferral concession is taken, any appreciation in value to the cessation time is taxable.

When the taxing time is able to be deferred under the “deferral concession” to a future “cessation time”, and the taxpayer does not dispose of the share or right within 30 days in an arm’s length transaction, the amount to be included in assessable income (at that time) is the market value of the share or right at cessation time, less any consideration given, including any amount paid to exercise a right to acquire a share.193

A special rule applies to options which are allowed to lapse. Where a right to acquire a share is lost without having been exercised (whatever the reason), the right will be taken never to have been acquired, and any tax paid on initial acquisition of the right will become refundable through an amended assessment if necessary.194

9.5.5 Complex valuations of shares and rights required

Division 13A contains rules for determining the market value of both listed and unlisted shares and rights on a particular day.195 While the valuation of listed company shares is reasonably easy, particular difficulties arise for unlisted shares and rights – ie shares and rights in companies not listed on a stock exchange. This will be the normal scenario for an IP spin-off company.

187 For the position where the trust is an employee share trust, see further below. 188 Section 139GE ITAA 1936 which incorporates the definition of “associate” in s 26AAB. 189 Section 139D ITAA 1936. 190 Section 139CD(3) ITAA 1936. 191 Section 139CC(2) ITAA 1936. 192 Section 139CC(3) ITAA 1936. 193 Section 139CC(4) ITAA 1936. 194 Section 139DD ITAA 1936. 195 Subdivision F of Division 13A, ITAA 1936.

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Quite complex rules apply for determining the market value of unlisted rights depending on whether the right must be exercised within 10 years or not.196 For example, a 10 year option with an exercise price equal to current market value of the underlying share will have a taxable value of 18.5% of the exercise price/current market value.197 In the case of both unlisted shares and unlisted rights, the issuing company will often need to have valuations done by qualified valuers at the time shares or rights are being provided. This can give rise to significant cost issues, and may even cause commercial problems for companies with sensitivity as to the value of their IP assets. Hence, it can provide a significant deterrent to use of such schemes by start-up IP spin-off companies.

9.6 Qualifying for concessions As already noted above, in addition to setting out that the acquisition of shares at a discount will prima facie give rise to the “acquisition discount” being taxed as income, Division 13A also provides two concessions if certain conditions are met. In order to be eligible for either concession, however, the shares (or rights) must be “qualifying shares or rights”.198

9.6.1 “Qualifying” shares and rights

There are six conditions relevant to determining whether a share is a “qualifying share” but only five of those conditions apply in determining whether a right is a “qualifying right”:

(a) The share or right must be acquired under an employee share scheme.

(b) The shares must be in the company which is the employer of the taxpayer or in the holding company of the employer company. (This means the concessions are not available if the recipient is not in an employment relationship (eg is an independent contractor), or if shares or rights are acquired by an associate of an employee, or if the shares are shares in an unrelated company).

(c) All the shares must be ordinary shares and the rights must be rights to acquire ordinary shares.

(d) In the case of shares, at least 75% of permanent employees must be entitled (or have been entitled) to participate in this or another employee share scheme. This condition does not apply to rights.

(e) The taxpayer’s legal or beneficial interest in shares of the company must not exceed 5%.

(f) The taxpayer must not be in a position to control more than 5% of the votes that could be cast at a general meeting of the company.

9.6.2 Problems faced by IP spin-off company in meeting conditions

Several of these conditions make it difficult for the concessions to be accessed by unlisted companies generally and new companies in particular. In addition, the concessions are more onerous for the issue of shares than the issue of options.

196 Sections 139FC and 139FJ to FN ITAA 1936. 197 Section 139FM ITAA 1936. 198 Section 139CD ITAA 1936.

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For example, the requirement, in relation to shares, that the scheme or another scheme be available to 75% of permanent employees means that new companies are effectively unable to satisfy the requirement. This is because the term “permanent employees” is defined as full-time or permanent part-time employees with at least 36 months service.199 It should be noted that the Commissioner does have discretion to determine that the condition has been satisfied200 and it may be that in the case of a new company the Commissioner would do so if the scheme was open to 75% of current employees.

Although the condition does not apply to option plans, some of the other conditions may mean that the concessions are unsuitable for start-up companies. For example, the restrictions relating to ordinary shares and the 5% limit may make the schemes unattractive to intellectual property providers who wish to receive preferential share rights or to take a larger stake in the company.

The House of Representatives Standing Committee made a number of recommendations to ease some of the requirements for qualifying shares and rights, particularly to facilitate the use of employee share schemes in “sunrise enterprises”.201 The Government, however, did not support any of those recommendations.202

9.6.3 Other problems with concession conditions

It may also be noted that, even if the conditions for the concessions could be satisfied in a spin-off company situation, they depend on the individuals who agree to contribute their labour to the company still being treated as mere employees rather than equity partners in the arrangement. In particular, the concessions require that the shares be received not as the unfettered property of the individuals, but rather subject to conditions preventing them having the right to dispose of the shares or otherwise enjoy the full benefits of ownership of an equity interest for a prescribed period. This puts them in a commercially disadvantaged position relative to the other parties contributing to the company, such as venture capital parties contributing finance. This is commercially untenable, given they are contributing their labour at risk.

9.7 The operation of the exemption and deferral concessions

If the shares or rights are qualifying shares or rights, the taxpayer may be able to claim the exemption concession or the deferral concession, but not both. The taxpayer must make an election as to which applies in any single year.203

9.7.1 The exemption concession

A taxpayer who acquires “qualifying shares or rights” may elect to have the acquisition discount included in assessable income in the year in which the shares or rights are acquired and receive $1000 worth of discount tax-free204 if three additional conditions are satisfied. These are:

(a) first, there must be no forfeiture of ownership conditions under the share plan;

199 Section 139GB ITAA 1936. 200 Section 139CD(5) ITAA 1936. 201 House of Representatives Standing Committee Report, f/n 52, Recs 32-39. 202 Federal Treasurer’s Press Release 14/03, 27 March 2003. 203 Sections 139BA and 139E ITAA 1936. 204 Section 139BA(2) ITAA 1936.

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(b) second, shares or rights may not be disposed of for a minimum of three years (unless employment ceases earlier); and

(c) third, the scheme and any related scheme for the provision of finance must be operated on a non-discriminatory basis.205

An employee share scheme or a related scheme for the provision of finance will be non-discriminatory if it is open to at least 75% of permanent employees and the essential features of the scheme for all participants are the same.206 Again the reference to permanent employees as full or part-time employees with at least 36 months service makes this condition impossible to satisfy for start-up companies.

9.7.2 The deferral concession

To attract this deferral concession, the share or options must be subject to conditions or restrictions which prevent their disposal by the employee until a future time or render them liable to forfeiture until a future time. If the shares or rights are qualifying shares or rights and the taxpayer does not make an election to be taxed up-front, the discount amount will be included in assessable income at a future time, usually when those restrictions cease (referred to as the “cessation time”).207 However, if there are no restrictions preventing the taxpayer from disposing of the shares or conditions that could result in forfeiture, the concession, in effect, will not apply.208

In the case of shares, the cessation time is the earliest of when the restrictions on disposal or possibility of forfeiture end, when the shares are disposed of, when employment ceases or the elapse of 10 years from issue.209

In the case of rights, the cessation time is the earliest of when the rights are exercised, when the rights are disposed of, when employment ceases or the elapse of 10 years from issue.210 If the right is exercised to acquire shares, and disposal restrictions apply to the shares, or the shares are subject to forfeiture, the cessation time is when the restrictions on the shares end (to a maximum of 10 years).211

As noted at 9.4.5 above, under the deferral concession, the employee is taxed on the market value of the shares at the cessation time (ie any appreciation in value since the acquisition date is also brought into account in calculating the tax liability).

9.8 Position of employer

The employer will ordinarily want a deduction for benefits provided to employees. In relation to deductibility, the issue of shares or rights by a company will not generally involve any cost to the employer, compared with the situation where shares or rights are acquired on-market.212 However, the 205 Section 139CE ITAA 1936. 206 Section 139GF ITAA 1936. 207 Section 139B(3) ITAA 1936. 208 Section 139CA(1) ITAA 1936. 209 Section 139CA ITAA 1936. 210 Section 139CB ITAA 1936. 211 Section 139CB(1)(c) ITAA 1936. 212 The Federal Treasurer in Press Release 26/04 (30 April 2004) announced that there would be no change to the

deductibility provisions despite changes to the Accounting Standards relating to expensing options granted to employees.

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company providing the shares or rights under an employee share scheme (either the employer or the holding company of the employer company) may be entitled to claim a deduction for some of the costs associated with the scheme. For example, it should be possible to claim a deduction under the general deduction provision for the costs associated with setting up and administering scheme.213 Where a deduction would not otherwise be available, Division 13A provides a deduction to a maximum of $1000 for shares or rights that are qualifying and also satisfy the exemption concessions.214 Contributions of money or property to an employee share trust may also be deductible but only at the time the employee or associate acquires the shares or rights215 (see below).

A final issue for employers is whether the provision of shares or rights under an employee share scheme will give rise to a fringe benefits tax liability – this is discussed in 9.9 below.

9.9 Other taxing provisions

On general principles it is possible that the provision of shares or rights as remuneration could give rise to tax either as a non-cash benefit or as a fringe benefit. It is also possible that any subsequent disposal of the shares or rights could give rise to capital gains tax liability.

The provisions of Division 13A are an example of statutory income and as such an amount determined under the Division is included in assessable income.216 If Division 13A applies then a number of other taxing provisions such as section 26(e) (employment benefits) and section 21A (business benefits) are expressly excluded from applying.217 However, those provisions may need to be considered if Division 13A does not apply to a share plan (see below).

Prima facie, the provision of shares or rights would give rise to a liability for the employer to pay fringe benefits tax. However, the definition of “fringe benefit” expressly excludes a benefit constituted by the acquisition of a share or right that falls within Division 13A218 or the acquisition of money or property by certain employee benefit trusts219. It should be noted, however that the provision of other benefits, such as the provision of financial assistance to acquire the shares or rights, could give rise to fringe benefits tax liability for the employer.

A final point to note is that the subsequent disposal of shares or rights may give rise to capital gains tax liability. The interaction between Division 13A and the capital gains tax provisions is considered below.

9.10 Interaction with CGT

The general position in relation to shares issued at a discount to market value to employees is that:

(a) the discount on market value received on acquisition of the shares will be taxed on acquisition under Division 13A (subject to the concessions), but

213 Section 8-1 ITAA 1997. 214 Section 139DC ITAA 1936. 215 Section 139DB ITAA 1936. 216 Section 6-10 ITAA 1997. 217 Section 139DE ITAA 1936. 218 Section 136(1) Fringe Benefits Tax Assessment Act 1986 (FBTAA 1986), definition of “fringe benefit”, para (ha).

There is also an equivalent provision for benefits provided under a previous legislative scheme applying to employee share schemes in existence before 1995 (para (h)).

219 Ibid, para (hb).

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(b) if the employee subsequently disposes of the shares, the employee will be treated as having acquired the shares at a cost equal to their market value on the date of acquisition, so that the difference between market value and consideration on disposal will be taxed as a capital gain.220 As a general rule the disposal of a share or right will give rise to a capital gain if the consideration on disposal (or in certain cases the market value at disposal) is greater than the cost base of the share or right.221 A capital loss will arise if the capital proceeds are less than the reduced cost base.222

The general position described above applies only if the discount on shares or rights is subject to tax on acquisition, if the acquisition discount is taxed at acquisition, or if the exemption concession is claimed at acquisition. If it is taxed at acquisition, the cost base of the share or right will be taken to be its market value at the time of acquisition.223 This means that the discount will be taxed under Division 13A and the taxpayer will then be able to use the market value at the time of acquisition to determine the capital gain or loss.

The general position described above does not apply if the taxpayer has elected for the “deferral concession” and not been subject to tax on acquisition. If tax is deferred and the share or right is disposed of within 30 days of cessation time, the capital gains tax provisions do not apply.224 This means that the difference between market value of the share or right and the amount the taxpayer paid to acquire it will be subject to tax under Division 13A.

If tax is deferred and the share is disposed of more than 30 days after cessation time, the cost base of the share is market value at cessation time.225 This means that the difference between market value of the share or right at cessation time and the amount the taxpayer paid to acquire it will be subject to tax under Division 13A. Any subsequent increase in the value of the share or right will be subject to tax as a capital gain.

9.10.1 CGT discount

An important point to note is that since September 1999, certain capital gains have been eligible for the “CGT discount”, which means that only 50% of the nominal gain is included in assessable income.226 This may mean that it is advantageous to bring forward the taxing time under Division 13A and receive less of any relevant gain in the value of shares or rights as an “income” gain subject to tax under Division 13A, and more of any relevant gain as a “capital” gain on disposal.

More importantly, the CGT discount reduces the value of the deferral concession. The deferral concession, while deferring the time at which the discount on acquisition of shares is taxed, until the restrictions on disposal or conditions of forfeiture cease (the “cessation time”), also ensures that any increase in the market value of the shares from their initial acquisition date to that cessation time is 220 Net capital gains and net capital losses are calculated under Parts 3-1 and 3-3 ITAA 1997. A net capital gain is

included in assessable income (s 102-5). A net capital loss can be carried forward and offset against future capital gains (s 102-15).

221 Section 104-10(4) ITAA 1997. Division 116 provides rules for determining “capital proceeds”. Divisions 110 and 112 provide rules for determining “cost base”.

222 Section 104-10(4) ITAA 1997. The reduced cost base is a modified cost base used to calculate a capital loss. It does not include certain costs that can be included to determine a gain (Subdivision 110-B).

223 Section 130-80(2) ITAA 1997. 224 Section 130-83(2) ITAA 1997. 225 Section 130-83(3) ITAA 1997. 226 Division 115 ITAA 1997. A number of conditions must be satisfied to take advantage of the discount eg the shares

must have been held for at least 12 months.

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fully taxed at ordinary income tax rates. By contrast, if the discount on acquisition is taxed at acquisition date, any subsequent increase in market value will be taxable subject to the CGT discount – ie only half the increase in value is taxable, so long as the shares are held at least 12 months.

9.11 The provision of shares or rights accompanied by a low interest loan

The provision of a loan by an employer (or associate or a third party under an arrangement) to an employee (or an associate) will attract the operation of the Fringe Benefits Tax Assessment Act as a benefit provided in respect of employment.227 The value of the benefit is the difference between a benchmark rate of interest and the rate of interest actually paid.228 If the loan is provided interest-free or at an interest rate below the benchmark rate, in general the difference will be subject to fringe benefits tax and tax will prima facie be payable by the employer at 48.5%.

However, if the loan is used to acquire income producing assets (the shares or rights), the value of the benefit will be reduced to zero under a rule known as the “otherwise deductible” rule.229 This is because, if interest had been charged, the employee could have claimed a deduction for it. When the “otherwise deductible” rule applies, the employer will not be subject to tax with respect to the loan benefit provided. Furthermore, the employee will not be subject to tax with respect to the loan.230

If the loan is used to acquire shares or rights at a discount, Division 13A will apply to the discount and if the conditions discussed above apply the employee will be able to access the concessions. However, if the loan is used to acquire shares or rights at full market value, the shares themselves will not be subject to Division 13A (as the share will not have been acquired at a discount. Hence no tax will apply.

A point for private (ie non-listed) companies is that the making of a loan to an employee who is a shareholder in the company (or an associate of a shareholder) could be treated as a deemed dividend from the company and therefore included in the assessable income of the recipient.231 There is however an exception if the loan is made solely for the purpose of enabling a shareholder or associate to acquire shares or options under an employee share scheme but only if the shares or rights are qualifying shares or rights within Division 13A.232

An alternative way in which to finance the acquisition of shares may be to enter into a salary sacrifice arrangement with the employee (see below).

9.12 The provision of shares or rights using an employee share trust

The provision of shares or rights through an employee share trust involves transferring shares or right or money or other property to a trustee to enable the trustee to acquire shares on-market and subsequently provide those shares or rights to employees or their associates. The use of such a trust can provide a number of benefits to an employer. For example, according to the House of Representative’s Report on employee share ownership one benefit is that it reduces the number of

227 Section 136(1) definition of “fringe benefit” FBTAA 1986. 228 Section 18 FBTAA 1986. The “benchmark interest rate” is determined by the Reserve Bank. For the FBT year

ending 31 March 2004 the rate was 6.55%. 229 Section 19 FBTAA 1986. 230 Sections 23L and 26(e)(iv) ITAA 1936. 231 Section 108 and Div 7A (ss 109B to 109X) ITAA 1936. 232 Section 109NB ITAA 1936.

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entities subject to taxation and focuses taxation liability on the beneficiaries of the plan.233 The tax benefits are considered below.

The provision of shares or rights to a trust, or the transfer of money or property to enable shares or rights to be acquired, will have no immediate tax consequences for the employee. This is because the employee will only acquire the share or right when they acquire the legal or beneficial interest in the share or right from the trustee. This is implicitly recognised in Division 13A which provides for deductibility in respect of the provision of money or property to a person for the purpose of enabling another person (the ultimate beneficiary) to acquire a share or right under an employee share scheme, but not until the ultimate beneficiary acquires the share or right.234 This suggests that the acquisition by the trust will not be treated as an acquisition by an associate of the employee even if the employee is “capable of benefiting under the trust”.235 Furthermore, the section dealing with acquisition of a share or right merely refers to acquisition from another person (not necessarily from the employer).236 For capital gains tax purposes, the first element of the cost base (or reduced cost base) is market value when the employee first acquired a beneficial interest in the share or right.237

The trustee of the employee share trust does not acquire a share or right under an employee share scheme if it is "the trustee of a trust whose sole activities are obtaining of shares, or rights to acquire shares, and providing those shares or rights to employees of a company or to associates of those employees".238 This is consistent with the general tax treatment of trusts. For capital gains tax purposes, where a beneficiary of an employee share trust becomes absolutely entitled to a share or right, any capital gain or loss the trustee (or beneficiary) makes is disregarded if the beneficiary is an employee of a company; the terms of the trust require or authorise the trustee to transfer shares or rights; the rights where acquired under an employee scheme and the employee did not acquire the shares for more than the trustee's cost base.239

An important consideration for the employer proposing to provide shares or rights at a discount is the issue of deductibility.240 This is because the issue of shares or options by a company does not generally involve a deductible outgoing, even though it clearly involves some sort of "cost" to shareholders of the issuing company. However, it is generally accepted that an employer will be entitled to a tax deduction under the general deduction provision241 in respect of a non-refundable contribution made to an employee share trust for the purpose of the trust using those funds to provide shares to employees of the contributor (by way of subscription or on-market acquisition) as part of an employee's remuneration package. This is implicitly recognised by a provision that allows a deduction where money or property is provided under a trust arrangement (although not until the employee actually acquires the shares or rights).242

Another advantage of establishing an employee share trust is that the provision of money or property to a trust will not attract fringe benefits tax where "the sole activities of the trust are obtaining shares, or rights to acquire shares in the employer company or its holding company and providing those shares

233 House of Representatives Standing Committee, f/n 52, pp.124-8. 234 Section 139DB ITAA 1936. 235 See definition of “associate” in s 26AAB ITAA 1936. 236 Section 139G(d) and (e). 237 Section 130-85(3) ITAA 1997. 238 Section 139C(5) 239 Section 130-90 ITAA 1997. 240 Other benefits of establishing an employee share trust include the fact that it facilitates forfeiture and disposal

where necessary. 241 Section 8-1 ITAA 1997. 242 Section 139DB ITAA 1936.

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or rights to employees or associates of the employees".243 As noted in 9.11, however, the provision of other benefits, such as financial assistance, may give rise to fringe benefits tax liability for the employer.

9.13 Plans that do not qualify for concessions

If shares or rights are offered at a discount to employees, but the shares or rights are non-qualifying in terms of the exemption or deferral concession, the benefit received will be subject to tax under Division 13A.

Examples include:

(a) Shares or rights in a company that is not the employer or the holding company of the employer;

(b) Where the recipient is not in an employment relationship but is an independent contractor;

(c) Where the recipient is an associate of an employee;

(d) Where the plan or another plan relating to shares is not open to at least 75% of permanent employees (ie employees with at least 3 years service with the company);

(e) Where the employee becomes entitled to more than 5% of the shares in the company; or

(f) Where the shares are not ordinary shares or the rights are rights to acquire shares that are not ordinary shares.

9.14 Plans that fall outside Division 13A

Division 13A is subject to two limitations. It only applies to shares or rights to shares. It also only applies where shares or rights are acquired at a discount to market value.

Hence, it may be possible to design an employee scheme which falls outside Division 13A. There are two situations that need to be considered. The first is a scheme that involves the provision of shares or rights at full market value, and the second is a scheme that offers interests that are not "shares or rights".

9.14.1 Offering shares or rights at full market value

The acquisition of shares or rights for a consideration equal to the market value of the shares or rights when they are acquired is not an acquisition under an employee share scheme and therefore not covered by Division 13A.244

Generally, the provision of shares or rights to employees for market value would not give rise to a benefit and so would not attract any tax liability. An employer may, however, prefer to provide the benefit by other means.

243 Section 136(1) FBTAA 1986, definition on "fringe benefit" para (hb). 244 Section 139C(3) ITAA 1936.

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For example, the provision of an interest free loan will generally not attract fringe benefits tax liability where the loan funds are used to acquire income-producing assets such as shares (see 9.11). However, the making of a loan in these circumstances may attract the deemed dividend provisions and the exclusion that applies where the loan relates to an employee share scheme within Division 13A will not be available (see 9.11).

Alternatively, the acquisition of shares or rights may be financed by a salary sacrifice arrangement. The main issue here will be to ensure that the salary sacrifice arrangement is “effective”. The Commissioner has indicated that such an arrangement will be effective if the arrangement is entered into before the amount to be sacrificed has been earned.245 If the arrangement is not effective, the Commissioner will treat the amount as having been derived by the employee and require the amount to be included in assessable income. The normal practice is to make these arrangements at the start of an income year.

Regardless of how the acquisition is financed, the employee will be able to derive any capital gains on the shares as a discount capital gain and only pay tax on 50% of the nominal gain. This may be regarded as a preferable way to provide the benefit particularly as it means that the shares or rights do not have to try to fit within the restrictive conditions that must be satisfied to enable an employee to access the Division 13A concessions.

The problem with these arrangements, however, is that they may expose the employee to unacceptable levels of financial and legal risk in the case of an IP spin-off company. This is particularly so in the case of a loan arrangement. Loan arrangements only work well if the employee can ultimately sell the shares for an amount in excess of the loan, keep the profit, and use the balance of the sale proceeds to repay the loan. Given the nature of an IP spin-off company’s activities, there is a high risk the shares in a spin-off company will decline in value. If the shares decline in value below the loan amount, the employee will have to repay the loan from his or her own financial resources. If the spin-off company forgives the loan, the debt forgiveness is a fringe benefit taxable at 48.5%.

It is also inappropriate for the employee to be subject to a significant loan liability, where they have agreed to forgo a normal cash salary to work for the company. This amounts to employees paying the company to employ them to work for nothing.

9.14.2 Schemes that offer interests that are not shares or rights

Division 13A only applies when the interest being provided is a "share or right". Some employers have chosen to step outside the Division and offer benefits that replicate share ownership but do not involve the acquisition of shares or rights. These schemes are sometimes referred to as "replicator share plans" or "phantom", "synthetic" or "shadow" plans.

The House of Representatives Committee that considered employee share schemes noted that replicator share plans are used "where the company cannot or is unwilling to issue equities in itself".246 The plans provide benefits to employees that "mimic the benefits they would have received had they held shares in the company".247 Benefits provided under such plans will not be subject to tax under Division 13A and will not be eligible for concessions under that Division. Any non-cash benefit received by an employee in respect of employment will be subject to tax either under s 26(e) ITAA

245 Taxation Ruling TR 2001/10. 246 p.xxi. 247 Ibid.

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1936 (which requires the recipient to include the value to the taxpayer of the benefit in assessable income) or as a fringe benefit (in which case the employer will pay tax on the value of the benefit as determined under the FBTAA 1986). Typically the plan will aim to provide the benefit at market value to avoid payment of tax and to provide the benefit either in the form of a low or interest-free loan or salary sacrifice to fund the acquisition of the interest. Alternatively, or in addition, the benefit may be derived if the shares when subsequently disposed of are eligible for discount treatment.

Although these types of schemes may avoid the operation of Division 13A, the House of Representatives Standing Committee noted that they were not used very much in Australia.248

9.15 Partnership compared

In considering the unsatisfactory taxation treatment afforded the contribution of labour in exchange for equity interests in a spin-off company, it is useful to compare the position which would arise if a general law partnership was the commercialisation vehicle.

If the parties were to adopt a general law partnership as the commercialisation vehicle, the tax outcomes would be far superior. The individuals who agree to contribute their labour in exchange for an equity share would become partners in the partnership and agree to provide their labour as partners. They would not be subject to tax on the initial receipt of their partnership interest;249 in particular, they would not be taxed as having earned the partnership interest in exchange for their labour. Rather, they would simply be subject to the normal fiscal consequences of having obtained a partnership interest: if the partnership were to derive actual profits as a result of successful commercialisation of the intellectual property in future years, they would be liable to tax on their actual share of the realised net income of the partnership at that time. There would be no taxation of unrealised potential income, and no double economic taxation if and when that potential is realised.

9.16 Conclusions – current law unsatisfactory

The unfavourable tax treatment afforded the contribution of labour to a spin-off company in exchange for equity interests, has the inevitable tendency to force the parties to choose between abandoning the employee share proposal or adopting sub-optimal employee equity arrangements. For example, parties may be forced to adopt alternative employee share plan arrangements such as: (a) informal, non-binding undertakings that shares will be made available if favourable commercialisation outcomes are achieved; interest free loans to enable employees to purchase shares at market value; (b) ‘phantom’ share plans where employees are promised future cash payments based on the value of a notional share allotment; or (c) free options to purchase shares at prices set just above their existing market value, so that they are taxable only on subsequent increases in value as and when the options are exercised and the shares sold.

None of these are satisfactory from a commercial perspective. Informal undertakings would not create a taxable share interest, but would leave the employee in a commercially untenable position of contributing labour without the protection of an enforceable legal arrangement. An interest free loan to purchase shares will not attract fringe benefits tax, but as discussed, this may have other tax costs,

248 House of Representatives Standing Committee Report, f/n 52, p 20. 249 In addition, there would be rollover relief to ensure no deemed taxable gains in respect of the change of partnership

interests in the depreciating intellectual property assets held by the partnership: see section 40-340(3) of the ITAA 1997.

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such as deemed dividend treatment. It also leaves the employee with a debt owed to the company, which is commercially inappropriate, given they have contributed their labour to the company.250 Phantom share plans deprive the individual of an actual equity interest, which is again commercially untenable if they are contributing their labour on terms which subject them to the same economic risks as an actual shareholder. Options to purchase shares at prices set just above their existing market value may defer tax, but this is on the basis that the options have nominal value at the date of issue. While such arrangements may be appropriate forms of additional incentive in the context of company executives already receiving substantial cash salaries, to issue options with no present value is commercially inappropriate in the context of an IP spin-off company where the employee is initially contributing their labour to the company for no other recompense, since the terms of the option give them no credit for the value of that labour.

In short, the general income tax treatment afforded by Australian tax law to employee shares in an IP spin-off company does nothing to encourage, and much to discourage, intellectual property commercialisation. As discussed in Appendix C, it appears a more favourable regime applies in the United States. This could provide a useful basis for evaluating potential reforms to the Australian regime.

250 And potentially liable to fringe benefits tax if not repaid in full.

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Chapter 10 Problems with start-up losses in use of spin-off companies for commercialisation of intellectual property

Expenditure incurred in the initial phases of intellectual property commercialisation activity will typically exceed income earned in that phase, resulting in ‘start-up’ losses. The parties to a business enterprise which incurs start-up losses will ordinarily look to obtain tax deductions for those losses. They will represent both an actual cash outflow, and a true economic loss. As identified in Chapter 7, however, use of a company as the vehicle for intellectual property commercialisation causes problems in relation to “start-up losses”. This Chapter looks at these problems.

The ideal position for a taxpayer in respect of losses on a commercial investment is that the taxpayer who suffers the economic losses should be able to recognise the losses as deductions against their other income as the losses are incurred. This will ensure that the present value of the deductions for the losses is maximised, thus reducing the after-tax cost of the investment in the phase in which is generating losses.

Example 9

Based on the facts in Example 1 in Chapter 7, assume that the venture capitalists contribute financial capital of $2.5m to the spin-off company and the entire capital contribution is expended on tax-deductible operational expenditures in the current year. If there is no income generated at this early stage of capitalisation, those deductible expenditures become, effectively, tax losses of the enterprise. If those tax losses were to be fully deductible to the investors at that time, the after-tax cost of the investment would fall by 30% (or $0.75m= 2.5m x 30%). The government would, in effect, finance 30% of the investment’s cost.251

10.1 General economic analysis of risk and treatment of start-up losses

The taxation treatment of start-up losses is a critical controlling factor on decisions to invest in intellectual property commercialisation. Tax deductions for business losses reduce the cost, and hence the risk of all forms of business investment.252 Hence, as the risk levels of an investment increase, the value of deductions for any losses becomes correspondingly more significant. Given the high risk levels associated with intellectual property commercialisation, the importance of the tax treatment of the losses is of the first order.

Tax losses associated with intellectual property commercialisation need to be analysed from four perspectives.

(a) The first is the quantum of the losses: will the investors in the commercialisation enterprise obtain deductions for all, part or none of the losses?

251 Bankman, Joseph (1994) “The Structure of Silicon Valley Start-up”, 41 UCLA Law Review 1737, at p.1742. 252 Domar and Musgrave, “Proportional Income Taxation and Risk-Taking” and Brown, “Business-Income Taxation and

Investment Incentives” in Shoup and Musgrave (eds), Readings in the Economics of Taxation, pp.493 and 525.

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(b) The second is the present value of the deductions for the losses: will investors obtain an immediate deduction for the losses (meaning their present value is not discounted) or will the realisation of the losses for tax purposes be deferred (meaning their present value is at a

(c) The third is transferability

discount to their nominal value)?

: if the investors cannot claim the losses themselves, can they recoup

(d) The fourth is reversal

the value of the losses by transferring them for value to another person who can use them?

of deductions for the losses: are deductions a permanent tax saving, or

wever, where an intellectual property commercialisation is undertaken though the use of an IP spin-off company, this generally favourable operation of the tax system is subject to

deducted immediately against other income of the investor). This capacity is not, however, present in

tion activity against their other income, because the losses are treated as being made by the spin-off company, and not by its shareholders. That is, for tax purposes, the losses are “trapped” in

ation activity. Even if the start-up losses are deductible in the future years, due to the time value of money and inflation, the

sses for

can the benefit of the deductions be effectively reversed by later transactions?

In general, Australian tax law allows a deduction for business losses of an entrepreneur or investor to be claimed against other income of the party which incurs the loss, thus reducing tax on the other income. In this way, the risk and burden of the loss is shared between the entrepreneur or investor and the government. Ho

certain constraints.

10.2 Problems with use of IP spin-off company

The capacity to use investment losses as an immediate deduction against other income is one of the features of current Australian income tax law which encourages negatively geared investment in shares and property (interest and other expenses in excess of income on such investments may be

the case of intellectual property commercialisation activity through the medium of a spin-off company.

As discussed in Chapter 7 at 7.6, the income tax law will prevent the parties who form the spin-off company from being able to directly apply the tax deductible losses associated with the commercialisa

the company.

This is so, notwithstanding that the shareholders are economic partners in the enterprise, and will have contributed (and lost) the monetary and other resources which have funded the expenditure which constitutes the losses. The losses will only be able to be used by the spin-off company as a tax deduction against future profits, if any, of the spin-off company’s commercialis

deferred deductions will have a lower present value than if currently deductible.

Furthermore, the deduction of the start-up losses against future profits is by no means assured even if the future profits are in fact realised. Under the company taxation rules concerning carry-forward of tax losses, tax losses from an early year can only be used against profits from a later year if there is on-going continuity of majority ownership of the spin-off company, or alternatively no change in its business activity, from the loss year to the profit year.253 If the spin-off company fails to generate future profits, or fails to generate sufficient future profits to utilise all the losses, or has a relevant change in ownership and business, there will never be any realisation of the value of those lo

253 The continuity of majority ownership and same business requirements apply to company losses under Division 36

and 165 of the ITAA 1997.

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Problems with start-up losses in use of spin-off companies for commercialisation of intellectual property

income tax purposes. This will be so, notwithstanding that the losses represent actual current year cash-flows suffered or incurred by the economic partners in the commercialisation enterprise.

by them as immediate deductions against their other income in

uld have the tendency to encourage those engaging in intellectual property commercialisation to favour non-

her than a spin-off company, notwithstanding the fact that the partnership is commercially less efficient than the company form.

ties to the intellectual property

and is not to be preferred over the company form from a commercial perspective. Further, the rollover

orm of depreciating assets to a partnership, mentioned in Chapter 8 at 8.5, may not apply to a contribution to an unincorporated joint venture.

10.5 Problems in relation to R&D concession

development by reducing the after tax cost of expenditure. It does this by offering a concessional duction is trapped in the

IP spin-off company, and not able to be realised immediately against other income, the present value of the concessional deduction is reduced.

10.3 Position of partnership compared

In contrast, as discussed in Chapter 7 at 7.6, if a general law partnership is adopted as the commercialisation vehicle, it is treated as a ‘flow-through’ entity for income tax purposes. So, the deductible tax losses of the start-up phase flow through the partnership to the partners in the year they are incurred, and are able to be used that same year. As a result, the present value of the deductions for the losses is maximised, thus reducing the after-tax cost of the commercialisation expenditure in the phase in which is generating losses.

Where the intellectual property contributor or contributors is, or includes, a tax exempt institution, that institution will not be able to use the tax losses in any event. As such, its own investment decision will be neutral as to this issue. However, to the extent the parties are taxpaying entities, the different tax treatment of start-up losses as between a spin-off company and an unincorporated vehicle such as a partnership will be of significant concern. As a result, this feature of the income tax law wo

corporate business structures, such as a partnership, rat

10.4 Unincorporated joint venture compared

An unincorporated joint venture shares with a partnership the advantage that start-up losses “flow through” to the venturers. A joint venture also offers several, rather than joint, liability for debts, losses and liabilities of the enterprise. Hence, if the parcommercialisation were to instead adopt an unincorporated joint venture structure to carry out the commercialisation, this would have the advantage of allowing each party to deduct directly its share of tax deductible expenses and losses of the joint venture.

However, an unincorporated joint venture lacks the commercial flexibility of a spin-off company

relief for contribution of intellectual property in the f

The problems associated with start-up losses being trapped in an IP spin-off company are also relevant to the operation of the R&D concession.

As noted in Chapter 6 at 6.1, the R&D concession for expenditure on research and development is generally only available to companies – in particular, it is not available to partnerships (other than partnerships of companies). The R&D concession is designed to encourage investment in research and

deduction – usually 125% of the value of the expenditure. However, if the de

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This means the concessional deduction will not achieve its intended purpose.

10.6 Problems with distributions of profits which recoup losses

Problems also arise when IP spin-off companies distribute profits which recoup start-up losses.

so be significantly reduced for

ment would allow the losses to “flow-rough” to shareholders for deduction against their other income, thus restoring the present value of

the deductions. A similar rule to this applies under US tax law.

Chapter II discusses this.

10.7 Conclusion – reform needed

The treatment of start-up losses in IP spin-off companies is sub-optimal. Because the losses are “trapped” in the IP spin-off company, the present value of the associated tax deduction is significantly reduced. In addition, the present value of any R&D concessions will althe same reason. This will reduce the general attractiveness of investment in an IP spin-off company, and in particular, also reduce the effectiveness of the R&D concession.

Reform is needed. Consideration should be given to allowing IP spin-off companies to elect to be treated as partnerships for taxation purposes. This kind of treatth

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Chapter 11 Problems in use of spin-off company for distribution of commercialisation income and realisation of capital gains

The income tax law will tend to inhibit the formation of IP spin-off companies, if the adoption of the spin-off company form as a commercialisation vehicle operates to impose an effective rate of income tax on the ultimate proceeds of commercialisation, which is higher than the effective rates which would apply were the company form not adopted. As identified in Chapter 7, use of an IP spin-off company may cause taxation problems in relation to subsequent distributions of commercialisation income, which have the consequence that the effective tax rate is increased. This Chapter analyses the problems in more detail, and also contrasts the position in relation to capital gains.

11.1 Problems For Tax-Exempt Institutions In Use Of Spin-Off Company

Where the shareholders in a spin-off company are Australian taxpaying entities, and the spin-off company generates sufficient revenues to pay dividends, then in the ordinary situation, the corporate form will generally lead to the same tax treatment as a direct investment, or an investment in a general law partnership. Where there is taxation of profits in the company (at a 30% rate) and then distribution of those profits as a franked dividend under the imputation system, imputation credits result in the overall tax being the same as if the income had been earned directly.

However, a higher effective tax rate may be produced by use of the spin-off company form where the intellectual property contributor or contributors is, or includes, a tax exempt institution. This is because the company will prima facie be subject to tax at 30% on its taxable commercialisation profits. The tax exempt status of the intellectual property contributor as a shareholder, even if it is a significant or controlling shareholder, will not preclude the spin-off company being liable to company tax at the normal company tax rate on its taxable income.

This general treatment of the spin-off company form contrasts unfavourably with the position if a general law partnership is adopted as the commercialisation vehicle. As a general partnership is a ‘flow-through’ entity for income tax purposes, the commercialisation profits flow through the partnership to the partners, meaning that where the partner is a tax-exempt institution, the share of income allocated to that partner will be exempt from tax.

The problems for tax-exempt institutions may be mitigated in some cases. For example, certain classes of tax-exempt institutions can claim tax refunds for franking credits on franked dividends. This enables them, in effect, to restore the tax-exempt status of their share of the income. In addition, where the commercialisation income is untaxed, for example due to the spin-off company being able to deduct start-up losses from prior years against that income, the income can be paid as unfranked dividends to the tax-exempt institution without further tax.

11.2 Claw-back of losses on distributions of income by spin-off company

The company form can also produce higher effective tax rates for taxable participants in cases where the spin-off company has had start-up losses, in spite of the dividend imputation system.254 As noted 254 See Bureau of Industry Economics, Tax Concessions and Dividend Imputation, Research Report 44, AGPS 1993.

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in Chapter 10, start-up losses are “trapped” in the company. This means the losses will have to be used by the spin-off company as a tax deduction against future profits, if any, of the spin-off company’s commercialisation activity. If it is possible to deduct the start-up losses against the future profits (subject to satisfaction of the company taxation rules concerning carry-forward of tax losses), this will mean the future profits are, to that extent, sheltered from company tax in the hands of the spin-off company.

This tax shelter is, however, only effective if the parties are content to leave the commercialisation proceeds invested in the spin-of company. If it is desired to distribute the commercialisation proceeds to the shareholders, the distribution will be treated for income tax purposes as an unfranked dividend paid out of untaxed profits. The distribution will accordingly be subject to full taxation in the hands of the taxable shareholders, meaning that the tax shelter provided by the start-up losses is reversed or recaptured. In effect, the tax shelter is transitory and the losses of no permanent value to the taxable shareholders. This means that, simply by adoption of the company form, the taxable participants in the economic partnership have exposed themselves to an effective rate of tax on the commercialisation proceeds which is higher than it would have been if they were conducting the commercialisation venture directly in their own name.


This treatment of the spin-off company form, as already noted, contrasts unfavourably with the position if a general law partnership is adopted as the commercialisation vehicle. Since the general partnership is a ‘flow-through’ entity for income tax purposes, the start-up losses will flow through the partnership to the partners as they are incurred, meaning that the losses are not wasted where the partner is subject to tax. Then, when subsequent profits are earned, they also flow through directly, meaning that the effective tax rate is the same as if the taxable participant were conducting the commercialisation venture directly in their own name.

11.4 Unincorporated joint venture

If, as an alternative to a general partnership, the parties instead adopt an unincorporated joint venture structure to carry out the commercialisation, each party to the joint venture will be treated as deriving directly its share of commercialising income. This means the income will be exempt from tax where the party is a tax exempt institution.

For taxable participants, the unincorporated joint venture structure has the advantage that the start-up losses flow directly to them, and they are treated as deriving directly any subsequent profits, meaning that the effective tax rate is the same as if the taxable participant were conducting the commercialisation venture directly in their own name. This gives a better tax outcome than arises for a company.

11.5 Capital gains tax concessions – spin-off company offers superior outcomes

The discussion above has concerned the taxation treatment of commercialisation income derived by the spin-off company. It is necessary, however, to also consider the treatment of capital gains.

As noted earlier in this Working Paper (see Chapter 4, 4.2), capital gains attract concessional treatment under Australian tax law. Individuals are eligible for a 50% discount, and superannuation funds a

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Problems Use of spin-off company for distribution of commercialisation income and realisation of capital gains

66.66% discount, on capital gains on investments held for at least 12 months. The PDF and VCLP regimes also offer exemptions for capital gains.

If an IP spin-off company reaches the stage of commercialisation activity where it is generating significant revenues, then there will be a corresponding increase in the value of shares in the company. The shareholders can realise this increase in value by realising the capital gains on the shares, rather than by way of dividends paid by the company. The capital gains will attract the concessional treatment for eligible investors. Further, for tax-exempt investors, capital gains on the shares will also be tax-exempt.

The opportunity to access capital gains tax concessions is generally limited to IP spin-off companies. If, by contrast, the parties adopt a partnership or an unincorporated joint venture structure, they will be treated as holding direct interests in the IP assets, and other assets, of the commercialisation business.

These IP assets, and other business assets, will typically include a high proportion of assets which do not attract capital gains tax treatment on disposal. In particular, disposals of direct interests in depreciating IP assets such as copyright, patents and designs will not be eligible for CGT concessional treatment. Further, if the commercialisation activity involves the manufacture or production of trading stock, disposals of direct interests in the trading stock will not be eligible for CGT concessional treatment. Likewise, the proceeds of disposals of assets which have been the subject of deductions claimed under the R&D concession will be treated as revenue rather than capital gains.

As such, from the perspective of CGT concessions, the IP spin-off company offers superior outcomes to a partnership or unincorporated joint venture.

11.6 Can a partnership convert to a company to attract CGT concessions?

It should be noted, however, that a roll-over relief exists for a partnership to convert to a company, pursuant to Subdivision 122-B of the ITAA 1997.

Hence, one structural option may be to commence with a partnership to obtain the benefit of flow-through of start-up losses in the initial phase of commercialisation activity, then convert to a company so that CGT concessions can be accessed when the commercialisation activity begins to generate positive returns.

11.7 Can a unit trust attract CGT concessions?

The unit trust is a viable alternative to a spin-off company as a vehicle which offers partial access to CGT concessions. Units in a unit trust are treated as separate and distinct assets, for CGT purposes, from the underlying assets of the trust. Further the units are CGT assets eligible for the CGT discount if held by individuals or superannuation funds for at least 12 months prior to disposal.

11.8 Can a unit trust offer tax exempt income to tax exempt investors?

Another potential advantage of a unit trust is that income is treated as “flowing-through” to the unit holders, rather than being taxed in the trust. Hence, where unit holders are tax-exempt institutions, the income can “flow-through” to them and obtain tax-exempt treatment in their hands. In this respect, a unit trust can offer superior outcomes to a spin-off company.

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However, it should be noted that if tax-exempt institutions hold 20% or more of the units in a unit trust, Division 6C of Par III of the ITAA 1936 may deem the trust to be taxable as a company.255

11.9 Conclusions

A spin-off company is inferior to other vehicles in taxation treatment of commercialisation income. However, it is superior in terms of allowing access to capital gains tax concessions. The overall result is sub-optimal. Investors must trade off benefits against disadvantages whichever vehicle they adopt. This dilutes the full benefit of concessions such as the R&D concession and the CGT concession. It inhibits IP commercialisation by use of IP spin-off companies.

255 See section 102P(2).

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Chapter 12 Problems in tax treatment of commercialisation expenses of intellectual property spin-off company

In this Part, we briefly discuss some other aspects of the income tax law that will tend to discourage intellectual property commercialisation in a spin-off company. These features discourage investment in IP commercialisation by making the effective rate of taxation on intellectual property commercialisation proceeds higher than the effective rate which might be expected to apply to other forms of investment, in particular, lower risk activities such as investing in residential property. In this respect, it is necessary to give attention to the question of the general taxation treatment of expenditure on intellectual property commercialisation activity by a spin-off company (or by the contributors of intellectual property assets, labour or capital to the company).

12.1 Current position under Australian law

The taxable income of a spin-off company (like that of taxpayers more generally) will, broadly, equal the total of all commercialisation income less such items of expenditure as are allowed by the income tax law to be deducted against that income. The spin-off company will typically need to incur significant intellectual property commercialisation expenditure before it will be in a position to generate income. The effective rate of tax on the IP spin-off company will therefore depend on the extent to which the income tax law will allow it a deduction for the intellectual property commercialisation expenditure.

As the total of commercialisation expenditure for which a deduction can be claimed reduces, the effective rate of tax on the commercialisation income increases. If the effective tax rate is too high having regard to the relative risk associated with the investment in intellectual property commercialisation, there will be a tendency on the part of investors to prefer alternative and less risky investments, and intellectual property commercialisation will be inhibited.

12.1.1 Problems with capital allowances regime

We have outlined the general tax treatment of intellectual property assets in Chapter 4. Where a spin-off company acquires intellectual property for the purpose of developing it as an asset to generate commercialisation revenues, the intellectual property will constitute a capital asset of the spin-off company. This will mean that expenditure incurred in acquiring and developing the asset is to a large extent not deductible on favourable terms. Only limited depreciation deductions are available under the capital allowances regime for capital expenditure on certain kinds of ‘intellectual property’, specifically the legal or equitable rights as owner or licensee of patents, registered designs and copyright that are recognised under Commonwealth law, or equivalent rights under a foreign law.256 The effective lives of these rights are prescribed by statute, ranging from 6 years for a petty patent to 25 years for copyright.

The fixed effective lives set the period over which the cost of the patent, design or copyright must be ‘written off’ against income for taxation purposes, and the income tax law presumes that these prescribed effective lives will correspond to the actual period over which the intellectual property 256 Section 995-1(1) definition of ‘intellectual property’ in the ITAA 1997.

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declines in value to nil. Unlike the position with tangible depreciating assets, there is no flexibility in the law to allow the company to adopt a shorter effective life for intellectual property where technological developments, and the nature of the intellectual property, mean that its actual effective economic life will be shorter than the prescribed statutory life.257 Given a spin-off company will be operating in an industry subject to rapid technological change, this inflexibility has the potential to lead to understatement of the true decline in value of the intellectual property, and a corresponding overstatement of taxable income. The result is that the effective tax rate on commercialisation income will be higher than it should be under a correct calculation of actual effective life.

Important forms of intellectual property are omitted from the list of intellectual property assets eligible for depreciation under the capital allowance rules. There is no capital allowance depreciation for expenditure on trade secrets and confidential information, a potentially significant limitation where the intellectual property is not of a kind able to be protected under the laws of copyright, patents or designs, or where there are good business reasons for not seeking the protection of patent law for trade secrets or confidential information. The failure of the income tax law to recognise the cost of capital expenditure on such intellectual property has the potential to lead to understatement of the true cost incurred by the spin-off company in generating its commercialisation income, meaning that the effective tax rate on the intellectual property commercialisation income will be higher than it should be under a correct calculation of the actual economic cost of earning the income.

There is also no capital allowance depreciation for trade marks, brand names and other forms of intellectual property associated with the marketing and distribution of products, which may well be a significant limitation in the context of a commercialisation business. This again has the potential to lead to understatement of the true costs incurred by the spin-off company, and an effective tax rate on its commercialisation income which is higher than it should be under a correct measurement of actual economic profit.

The position with tax treatment of capital expenditure on intellectual property assets is summarised in the table below:

Asset Treatment Standard patent Depreciate over 20 years Innovation patent Depreciate over 8 years Petty patent Depreciate over 6 years Registered design Depreciate over 15 years Copyright Depreciate over 25 years Trade marks No depreciation Trade secrets / know how / confidential information No depreciation Brand names No depreciation Goodwill No depreciation

257 Section 40-110(5) of the ITAA 1997.

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Problems in tax treatment of commercialisation expenses of intellectual property spin-off company

12.1.2 Proposed reforms of capital allowances regime

The federal government has been reviewing the case for generally extending the range of expenditures of a capital nature eligible for deductions258.

A limited extension to those rules has been provided as a result of the Review of Business Taxation, so as to allow a deduction over the life of a project for certain kinds of ‘project expenditure’,259 such as amounts incurred on feasibility studies, to obtain information associated with a project, or in seeking to obtain a right to ‘intellectual property’ as defined in the limited sense of patents, copyrights and designs. The activities of an IP spin-off company might include project expenditure of this kind, but these provisions provide no systemic solution to the problems mentioned above concerning trade secrets and confidential information, or trade marks, brand names and other forms of intellectual property associated with the marketing and distribution of products.

As a general rule, the start up (and termination) costs of establishing an IP spin-off company would be capital and non-deductible. The capital allowance rules were also amended as a result of the Review of Business Taxation to allow the deduction of certain business related costs of a capital nature which did not relate to a depreciating asset or capital gains tax asset and were not otherwise deductible.260 The types of costs covered are limited to costs of establishing a business structure (such as cost of incorporating a company, or creating a partnership or trust), and costs of changing or terminating the structure (for example, liquidating a company). While an IP spin-off company might well incur expenditure of this kind, this provision would not cover expenditure on trade secrets and confidential information, or trade marks and brand names.

In the 2005 federal budget, the federal government announced it proposed to provide a systematic treatment for these so-called ‘blackhole’ expenses which do not currently obtain capital allowance relief. The “black-hole expenditures” issue has been carefully reviewed by government bodies and by industry organisations such as the Business Council of Australia.261 To date, however the government has not produced the detail of any potential legislative changes. The Press Release states as follows:

Changes to the Income Tax Assessment Act 1997 (the Act) will provide tax treatment for legitimate business expenses, known as ‘blackhole’ expenditures, for income tax purposes. Blackholes occur when business expenses are not recognised under the income tax laws. The need for an appropriate treatment for blackhole expenditures was identified in the Review of Business Taxation. The systematic treatment comprises: • permitting deductions for capital expenditures incurred by businesses that are carried on for a taxable purpose; • providing deductions for certain pre-business expenditures incurred by existing businesses; and • recognising these expenditures in a new provision that will only apply where the expenditures do not have tax

treatment, or are denied a deduction, elsewhere in the tax laws. Therefore, the new provision will be a provision of last resort.

Consistent with this systematic treatment, some blackhole expenditures will be recognised by increasing the range of expenditures that form the cost base of an asset for capital gains tax purposes.

258 The Minister for Revenue and Assistant Treasurer called for submissions in an announcement on 21 March 2003. A

public submission made by The Institute of Chartered Accountants in Australia, dated 11 October 2004 discusses a range of items which could be the subject of the reforms.

259 Section 40-840(2) of the ITAA 1997. The expense is generally written off for tax over the life of the project. 260 Section 40-880 of the ITAA 1997. The expense is generally written off for tax over 5 years (20% each year). 261 Review of Business Taxation, A Tax System Redesigned Section 8; Business Council of Australia & Andersen,

Removing Tax Barriers to International Growth (December 2001), pp.95-102. See also the comparative analysis in Review of Business Taxation, An International Perspective (Information Paper by Arthur Andersen) (December 1998 Chapter 4.

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The new provision will apply to expenditures incurred on or after 1 July 2005. Expenditure can be written off on a straight line basis over five years for the purposes of the Uniform Capital Allowance regime.

12.1.3 Australian tax law may encourage offshore transfer of intellectual property

The inability of a spin-off company to deduct expenditure on intellectual property assets such as trade marks and trade names contrasts with the position where such forms of intellectual property are not acquired by an Australian company as outright owner, but instead are used under license in exchange for fees or royalties: in this case, the fees or royalties will be deductible on an annual basis. These general features of the tax law seem to make it more sensible that such intellectual property be owned, not by Australian taxpayers, but rather by overseas taxpayers such as US entities, where the tax laws offer more favourable treatment of the capital costs of such asset, and merely licensed to Australian companies. Such a tendency would appear to lead to a sub-optimal outcome from the perspective of the Australian economy.

12.2 Tax treatment of intellectual property commercialisation expenditure in US and UK262

The restrictions on deductibility of capital expenditure on trade secrets and confidential information, or trade marks and brand names, under Australian income tax law, stand in contrast to the tax treatment of such expenses in other regimes such as the United States and the United Kingdom, where depreciation deductions are allowed for these intellectual property assets.263

The United States amortization rule applies to a comprehensive range of intangible assets, including patents, copyrights, designs and trademarks which are protected under the intellectual property laws, as well as other intangibles such as know-how, secret formula and process, trade name, and trade secrets. Taxpayers in the United States are able to claim deductions by amortizing the cost of, and further capital expenditures on, these intangibles over 15 years.264 With respect to self-created intangibles that are not amortizable, taxpayers may be able to claim a deduction for these capital expenditures as R&D expenditures, over 5 years.265 The deduction for R&D expenditures is broadly available to all types of entities, including corporations, general partnerships, limited liability partnerships and limited liability companies.

The 2002 United Kingdom tax reform adopted a flexible approach that aligns the deductibility of expenditures on intangible assets with accounting practice. A tax deduction for capitalised expenditures on an intangible asset may be allowable to a company taxpayer on an accounting basis, ie., reflecting a loss debited to the company’s profit and loss account.266 Alternatively, the taxpayer can choose to deduct the cost of the intangible asset over 25 years.267 Similar to the position in the United States, the term “intangible asset” covers patents, copyrights or design rights, registered designs, trademarks and “any information or technique … having industrial, commercial or other

262 This section was prepared primarily by Lillian Hong. See also Appendix B. 263 See Appendix B. 264 Section 197 of the US Internal Revenue Code. 265 Section 174(b) of the US Internal Revenue Code. 266 Paragraph 9, Schedule 29, Finance Act 2002 Chapter 23 (UK). 267 Paragraph 10, Schedule 29, Finance Act 2002 Chapter 23 (UK).

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economic value”.268 Expenditures on an intangible asset includes any expenditures to acquire, create, maintain, enhance, or establish or defend title to, the intangible asset.269

12.3 Conclusions

The ad hoc nature of capital allowance relief for expenditure on intellectual property and commercialisation activity does not help IP spin-off companies. This is another example of tax law inhibiting IP spin-off companies.

268 Paragraph 2, Schedule 29, Finance Act 2002 Chapter 23 (UK). 269 Paragraph 133, Schedule 29, Finance Act 2002 Chapter 23 (UK).

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Chapter 13 Problems in unwinding an intellectual property spin-off company structure

The discussion in Chapter 8 highlighted the potential tax and stamp duty costs realised on the initial contribution of intellectual property assets to a spin-off company. Parties contemplating an intellectual property commercialisation will also need to give attention to the tax and stamp duty costs which might arise should it be necessary for one or more of the parties to exit the spin-off company structure, or at least reduce their interest in the commercialisation venture.

13.1 Potential exit scenarios

In theory, the need to exit the structure might involve one of the following scenarios:

(a) unwinding of venture: all of the parties may wish to terminate the commercialisation venture and restore themselves to their original position – including the transfer of the intellectual property assets back to their original owners;

(b) one party exits: one of the parties may wish to terminate their participation in the commercialisation venture, but allow the others to continue it, in consideration of the other parties ‘buying out’ the first party at fair value;

(c) total exit: all of the parties may wish to terminate their participation in the commercialisation venture, by disposing of it to a third party;

(d) partial sell-down: all of the parties may wish to reduce their interest in the commercialisation venture, by allowing a third party to take up a new interest; and

(e) merger: the parties may wish to merge the commercialisation venture with another venture.

13.2 Spin-off company leads to taxation costs on exit or unwind

Where the parties have adopted a spin-off company as the commercialisation vehicle, then each of the termination events will involve taxable events.

If the termination scenario involves the spin-off company transferring the intellectual property assets back to the original owners (eg scenario (a) above)) this will potentially involve two taxable events. One is a taxable disposal of the intellectual property assets by the company. The other is a taxable event for the original owners, being receipt of either a taxable dividend, or a potentially taxable return of capital, with a value equal to the market value of the entity of the intellectual property assets. In such a case a better tax outcome may be secured by leaving the intellectual property assets in the company, and having the original owners instead buy-out the shares of the other shareholders in the spin-off company.

If the termination scenario involves one party disposing of their interest to the other parties (eg. scenario (b) above)), or a total disposal of all parties’ interests to a third party (eg scenario (c) above), one would expect this to be effected by a disposal of the shares in the spin-off company.

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This will be a taxable event to the shareholders, although capital gains tax concessions will reduce the rate of tax on any gains where the shares are held by individuals, and no tax will apply if the shares are held by tax-exempt institutions.

Other problems can arise from a share disposal. If it involves a change of 50% or more in the ownership of the company, it may mean the company loses the right to deduct previously accumulated tax losses against future commercialisation income, unless the spin-off company continues to carry on the same business as it carried on before the change.

13.3 Spin-off company has advantages on partial sell-down or mergers

On the other hand, the spin-off company has certain advantages, if the scenario is that the parties are wishing instead to reduce their interest in the commercialisation venture in favour of third parties. A third party can be given an interest by issuing them new shares for a market value consideration, and this will involve no taxable event for the company or the existing parties. It will, however, mean that the cash is contributed to the company’s business, rather than paid to the existing parties as consideration for a reduction of their interest.

Also relevant in this context is that the parties may wish to merge the business of their spin-off company with the business of another company, and take an interest in the combined enterprise. This can now be achieved without any tax cost by way of the ‘scrip for scrip’ roll-over relief rules.270 The owners of the spin-off company can exchange all their shares in the spin-off company for shares in another company, and not be subject to capital gains tax on the disposal.


The tax outcomes for a spin-off company may be compared to the termination scenarios with the alternative forms of business vehicle – i.e. partnership, trust or unincorporated joint venture.

In the case of a termination with ownership of the intellectual property assets transferred back to the original owners, it may be possible to terminate a partnership or unincorporated joint venture in a way which attracts lower tax costs than a company. This is because, in such a structure, the original owners will be treated as merely re-acquiring the fractional interest of the other parties – there will be no deemed disposal of the entirety of the intellectual property assets. Also, in the case of a partnership, roll-over relief may be available on re-acquisition of intellectual property assets in the form of patents, copyrights or registered designs.

In the case where the owners wish to dispose of part or all of their interest in the enterprise to a third party, the corporate vehicle will give the preferred outcome. This is because the CGT concessions, and scrip for scrip roll-over, will generally not be applicable where a partnership, joint venture or trust is used.

270 Subdivision 124-M of ITAA 1997.

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13.5 Conclusions

Use of a spin-off company to form a commercialisation venture has the disadvantage that termination of the venture, and return of the IP assets to the original proprietors, will generally result in taxable events for both the company and the shareholders. On the other hand, use of the company form has the advantage that the company can be merged “tax-free” with another company under “scrip-for-scrip” roll-over relief.

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Chapter 14 Concluding remarks

This Working Paper has examined taxation problems in the commercialisation of intellectual property, with particular attention paid to the problems faced by spin off companies that seek to commercialise intellectual property. We conclude that Australia’s income tax law has a clear tendency to inhibit the adoption of the spin-off company form as a commercialisation vehicle, and that this, in turn, reduces the effectiveness of the R&D Concession and the CGT concessions in stimulating investment in intellectual property.

We have illustrated this proposition by comparing the tax treatment of a spin-off limited liability company with the tax treatment of a general law partnership (or an unincorporated joint venture). The general operation of the income tax law clearly provides more favourable treatment to a non-corporate business structure such as a general law partnership (or unincorporated joint venture) in most respects as compared to a spin-off company. It does this in a number of ways, which we briefly summarise here:

(a) The contribution of intellectual property assets, such as patents, designs and copyright, to a spin-off company may trigger an immediate, large tax liability for the intellectual property contributors. This is because it is treated as an outright disposal of the whole interest in the assets to the company. In contrast, a “rollover” exists that defers the tax liability on contribution of many intellectual property assets to a partnership (in particular, patents, designs and copyrights). Further, for other assets, even if there is no roll-over, a contribution to a partnership (or joint venture) is treated only as a fractional disposal of a share of the asset.

(b) Intellectual property labour is frequently contributed to a spin-off company “at risk”, in that the contributors will agree to take nil or a low salary and instead, to be rewarded with a potential share of commercialisation profits through the grant of options or shares in the company. Except under very restrictive conditions (which will rarely be satisfied by a spin-off company), this will trigger immediate taxation on the value of the shares or options. In contrast, the contribution of labour to a partnership (or joint venture) in exchange for a share in the partnership (or joint venture) is not taxable.

(c) Start-up losses are trapped in the spin-off company and cannot be ‘flowed through’ to the investors to be offset immediately as tax deductions against other income or gains. This reduces the relative attractiveness of investment in IP commercialisation. In contrast, losses may be ‘flowed through’ to partners in a general partnership (or venturers in an unincorporated joint venture) and applied immediately as tax deductions against other income of the partners (or joint venturers). Further, when a spin-off company uses its losses as a deduction against its own future income, the benefit of carrying forward start-up losses is immediately reversed on distribution of that income to the shareholders because the distributions will be taxed as unfranked dividends.

(d) Commercialisation proceeds in a spin-off company are taxed at the 30% company tax rate, so that exempt investors (such as a University) cannot benefit fully from their exempt status. In contrast, commercialisation proceeds of exempt partners derived through a partnership will benefit from their exempt status (and the same applies to an unincorporated joint venture).

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The above list demonstrates the clear tax advantages of a general law partnership (or unincorporated joint venture) for early stage intellectual property commercialisation. Yet, it is clear that a general law partnership (or joint venture) is commercially less efficient than the company form. Further, the empirical evidence demonstrates that general law partnerships are not in fact used for venture capital commercialisation activities.

In addition, a partnership or unincorporated joint venture will not attract the benefit of the R&D concessions for start-up R&D expenditure or CGT concessions on disposals of interests in the enterprise. This means, in turn, that the R&D concession and the CGT concessions will be prevented from operating effectively to encourage the development and commercialisation of intellectual property.

The problems outlined in our Working Paper also appear to suggest that the tax law may be deterring intellectual property commercialisation altogether. Instead, the only commercially acceptable and fiscally viable option for Australian intellectual property creators and developers may be to license or sell their intellectual property, frequently to overseas operations. Alternatively, they may take the intellectual property offshore themselves to commercialise it in other markets, such as the US, where the fiscal regime is more favourable. Or commercialisation may simply not proceed.

Some alternative entities available under the tax law appear, at first glance, to be relevant for intellectual property commercialisation. We have examined the taxation of two specific venture capital entities: pooled development funds (PDFs) and venture capital limited partnerships (VCLPs). It is clear that the latter two entities, while attractive for certain kinds of venture capital investment and with a clear tendency to encourage commercialisation, are not suitable to be IP spin-off companies. Rather, they are venture capital vehicles that bring investors together to invest in company shares. Both PDFs and VCLPs require investment in company shares. This means that, in spite of their various tax advantages, they do not solve the problems of the spin-off company in the early stages of commercialisation, and, in particular, the problems of start-up losses. They will instead have a tendency to encourage capitalisation at the expansion and buy-out stages, where a successful venture requires further funding or can be managed or developed more successfully.

We have examined unit trusts. The unit trust structure provides superior tax treatment to a company, combined with the limited liability required for intellectual property commercialisation. But it fails to achieve the full benefits of the partnership (or joint venture) with respect to losses, because it does not allow flow-through of start-up loses. However, its flow-through tax treatment of commercialisation income has advantages. Hence, the unit trust is well suited to acting as a fund through which venture capitalists may come together to finance intellectual property commercialisation at a later stage of capitalisation, and its is also attractive to tax-exempt institutions.

An intellectual property commercialisation venture between intellectual property creators (such as University scientists) and capital providers is, essentially, an economic partnership in which all parties contribute assets or expertise and take commercial risks. Because of its risky and entrepreneurial character, the corporate form of the limited liability company is necessary. There seems to be a good policy reason for a rational tax law to recognise this commercial reality, in light of the government goal to encourage intellectual property commercialisation (by Universities and other publicly funded R&D) through spin-off companies.

Consequently, the tentative conclusion of this Working Paper is that there may be a case for amending the income tax law to allow parties to adopt the legal form of a spin-off company, but elect the flow through income tax treatment of a general partnership. This would enable contributors of intellectual

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Concluding remarks

property assets and labour, and contributors of capital, to take an equity interest in the spin off company but to receive the same taxation treatment as partners in the economic enterprise.

Provisions for a limited liability company, to elect to be taxed like a partnership, are a feature of the income tax laws of the United States. That flexibility in the United States income tax law is seen to have been an important factor in the growth of commercialisation of intellectual property in that country. Other countries have also taken steps in this direction; most recently, New Zealand in December 2004 enacted a limited partnership regime that has flow through tax treatment for losses. Such an elective mechanism for closely held businesses was in fact recommended by a review of the Australian tax system in 1975 but never implemented.271

Our conclusion on this aspect is tentative for several reasons. First, the development of any such proposal clearly requires a thorough comparative evaluation of the operation of the US and provisions and those in other countries. Second, careful consideration needs to be given of how such a measure would operate, and could be adapted, to the Australian context. It is intended that these issues will be further examined and a reform proposal will be developed after further work has been completed.

Our Working Paper also indicates a case for tax reform in the area of the contribution of IP assets, and labour, to a spin-off company. In relation to IP assets, a reform is necessary to ensure the contribution for shares is not a taxable event on formation of the IP spin-off company. Current law generally imposes a tax charge on contributions of assets, and this must tend to defer formation of IP spin-off companies. Again, a more favourable approach is taken in the US, as discussed by Lillian Hong in Appendix B to this report.

In relation to contributions of labour, our Working Paper has found (in Chapter 9) that current tax law discourages employee share ownership in IP spin-off companies. This, in turn, must tend to inhibit IP commercialisation, because cash-poor IP spin-off companies will find it difficult to attract and retain skilled knowledge-workers if tax law prevents them offering employee equity in lieu of cash salaries. The unfavourable treatment of employee shares will also inhibit development of the entrepreneurial ethic which is needed for IP commercialisation. As discussed by Lillian Hong in Appendix C, the US tax regime again appears to take a more favourable approach.

In short, current tax law presents considerable obstacles to the efficient commercialisation of intellectual property, and these obstacles will also negate the effect of the R&D concessions and the CGT concessions which are intended to encourage and increased investment in intellectual property. The case for reform is, we would submit, a strong one.

271 Asprey Review of the Australian Tax System, Final Report (1975) [16.79]-[16.96].

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Appendices

Table of Contents

Appendix A Federal Government Grant Programs Relevant to Intellectual Property Commercialisation ...................................... 109

A Commercial Ready........................................................................................................................................................................ 109

B R&D Start ...................................................................................................................................................................................... 109

C Biotechnology Innovation Fund (BIF)............................................................................................................................................ 109

D Commercialising Emerging Technologies (COMET) from 13 September 2004 .......................................................................... 110

E Innovation Access Program (IAccP) – Industry............................................................................................................................. 110

F Innovation Investment Fund (IIF) .................................................................................................................................................. 110

G Pre-Seed Fund .............................................................................................................................................................................. 110

H Renewable Energy Equity Fund (REEF)....................................................................................................................................... 110

I Renewable Energy Development Initiative (REDI) ....................................................................................................................... 110

J Small Business Incubator Program (SBIP) ................................................................................................................................... 111

K Small Business Entrepreneurship Program (SBEP) ..................................................................................................................... 111

Appendix B Taxation Of Intellectual Property Commercialisation: A Comparison of US Treatment............................................... 113

A Taxation of grants.......................................................................................................................................................................... 113

B Taxation of formation of IP spin-off company................................................................................................................................ 114

B.1 Taxation position on contribution of intellectual property to company........................................................................ 114

B.2 Patents and know-how ............................................................................................................................................... 115

B.3 Trademarks, trade names and franchises usually not capital assets......................................................................... 115

B.4 Copyright assets usually not capital assets................................................................................................................ 116

B.5 Other section 197 intangibles usually not capital assets ............................................................................................ 116

B.6 Taxation of gains on transfer of intellectual property assets ...................................................................................... 117

B.7 Taxation of contribution of IP assets to a resident company: section 351 - relief ...................................................... 117

B.8 Treatment of costs associated with IP........................................................................................................................ 122

C Taxation of formation of a partnership .......................................................................................................................................... 125

C.1 Section 721 relief ........................................................................................................................................................ 125

C.2 Meaning of “contribution” ............................................................................................................................................ 125

C.3 Meaning of “property” ................................................................................................................................................. 126

C.4 Problems with services ............................................................................................................................................... 126

C.5 Anti-avoidance rules ................................................................................................................................................... 127

C.6 Conclusions ................................................................................................................................................................ 128

D Taxation of formation of a resident limited partnership, a resident limited liability partnership, or a resident limited liability company....................................................................................................................................................................................... 128

E Taxation of formation of an unincorporated joint venture.............................................................................................................. 129

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Appendices - Table of Contents

Appendix C Taxation of Employee Stock Options in Start-up Intellectual Property Firms : A Comparison of US Treatment and Australian Treatment................................................................................................................................................................................... 131

A Introduction.................................................................................................................................................................................... 131

A.1 Benefits of stock options............................................................................................................................................. 131

A.2 Stock options in sunrise industry companies.............................................................................................................. 132

A.3 Types of stock options ................................................................................................................................................ 133

B Taxation of employee stock options in the US.............................................................................................................................. 133

B.1 Statutory Options ........................................................................................................................................................ 133

B.2 Non-qualified Stock Options ....................................................................................................................................... 139

C Comparison of tax treatment of employee stock options in Australia and in the US .................................................................... 141

C.1 Australian position ...................................................................................................................................................... 142

C.2 Comparison of Australian and US restrictions............................................................................................................ 142

C.3 Additional US restrictions............................................................................................................................................ 144

D Conclusion..................................................................................................................................................................................... 145

Bibliography................................................................................................................................................................................................. 147

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Appendix A

Federal Government Grant Programs Relevant to Intellectual Property Commercialisation

Lillian Hong

An alternative to using tax concessions to encourage increased levels of investment in intellectual property commercialisation is to provide direct government grants and subsidies. This Appendix A notes the term of some Federal grant schemes, as drawn from various Federal government websites.

A Commercial Ready

Commercial Ready is a competitive merit-based grant program supporting innovation and its commercialisation. It aims to stimulate greater innovation and productivity growth in the private sector by providing around $200 million per year in competitive grants to small and medium-sized businesses (SMEs) between 2004-05 and 2010-11. A wide range of project activities can be supported, extending from initial research and development (R&D), through proof of concept, to early-stage commercialisation activities.

B R&D Start

R&D Start is a competitive, merit based grants and loans program that supports businesses to undertake research and development and its commercialisation. The Australian Government is providing more than $1 billion to 30 June 2011 for the new Commercial Ready program. Commercial Ready forms part of the Backing Australia's Ability - Building our Future through Science and Innovation $5.3 billion package to follow on from the $3 billion Backing Australia's Ability strategy announced in 2001.

C Biotechnology Innovation Fund (BIF)

BIF is a merit-based competitive grants program which aims to increase the rate of commercialisation of promising biotechnology developed in Australia. It provides financial assistance to companies to demonstrate proof-of-concept between the initial research stage of a biotechnology project and the early stage of its commercialisation. The Australian Government is providing more than $1 billion to 30 June 2011 for the new Commercial Ready program. Commercial Ready builds on the Biotechnology Innovation Fund and commenced in October 2004. The final round of the Biotechnology Innovation Fund closed on 15 July 2004.

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Appendix A

D Commercialising Emerging Technologies (COMET) from 13 September 2004

COMET is a competitive, merit based program that supports early-growth stage and spin off companies to successfully commercialise their innovations.

E Innovation Access Program (IAccP) – Industry

The Innovation Access Program (IAccP) - Industry is a competitive program designed to foster innovation and competitiveness by increasing the take up of leading edge technologies and best practice processes by Australian firms, particularly SMEs. Applications are accepted from private sector companies; industry groups; universities; Cooperative Research Centres; training institutions; Commonwealth scientific organisations; and consortia of these. No further rounds will be called for the Innovation Access Program, as it is to be replaced by the Commercial Ready Program.

F Innovation Investment Fund (IIF)

Innovation Investment Fund is a Venture capital program that invests in nine private sector venture capital funds to assist small companies in the early stages of development to commercialise the outcomes of Australia’s strong research and development capability.

G Pre-Seed Fund

The competitive pre-seed fund for universities and public sector research agencies addresses the gap between promising scientific discoveries and commercialisation. It assists the commercialisation of public sector R&D activities by further developing the management and entrepreneurial skills of public sector researchers and build links with the finance and business community. This program forms part of the Backing Australia's Ability - Building our Future through Science and Innovation $5.3 billion package to follow on from the $3 billion Backing Australia's Ability strategy announced in 2001.

H Renewable Energy Equity Fund (REEF)

The REEF program is a specialist renewable energy equity fund based on the Innovation Investment Fund (IIF) model. It provides venture capital (equity) to assist small companies to commercialise R&D in renewable energy technologies.

I Renewable Energy Development Initiative (REDI)

REDI is a competitive merit-based grant program supporting Renewable Energy innovation and its commercialisation. REDI was announced on 15 June 2004 as part of the white paper, Securing Australia’s Energy Future. It provides grant funding up to $100 million in competitive grants to allocate to Australian businesses over seven years. It offers grants of between $50,000 and $5 million for research and development (R&D), proof-of-concept, and early-stage commercialisation projects with high commercial and greenhouse gas abatement potential.

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Federal government grant programs relevant to intellectual property commercialisation

J Small Business Incubator Program (SBIP)

The Small Business Incubator Program provides funding to not-for-profit organisations to help meet the infrastructure and set-up costs of new small business incubators. Smaller amounts are also provided for feasibility studies and to existing incubators for enhancements. Small business incubators assist start-up and developing new businesses by providing shared premises and business services, as well as intensive business advice and support. Tenant businesses are provided with an initial place of operation and a supportive environment in which to grow their business, before graduating into the wider business community. This forms part of the Australian Government's broader $60 million Small Business Assistance Program. SBIP closed on 25 November 2005 and has been replaced by the Small Business Entrepreneurship Program.

K Small Business Entrepreneurship Program (SBEP)

The Small Business Entrepreneurship Program is a highly competitive merit-based grant program that aims to assist in fostering entrepreneurship, including the growth potential and/or sustainability of small businesses. SBEP comprises two separate categories:

Category 1 – Business Skills Development:

• Training and Mentoring Projects (TMP)

• Incubators (Establishment funding and Post Establishment Growth funding)

Category 2 – Succession Planning

This program forms part of the Building Entrepreneurship in Small Business initiative and is funded until June 2008

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Appendix B

Taxation Of Intellectual Property Commercialisation: A Comparison of US Treatment

Lillian Hong

The purpose of this Appendix is to indicate how US tax law would treat the taxation problems in the commercialisation of intellectual property which have been discussed in relation to Australian tax law in the main body of this Working Paper. It is designed to provide a basis for future comparative work in relation to the problems. Statutory references are to the United State Internal Revenue Code and associated regulations.

A Taxation of grants

A general principle is that governmental subsidies/grants are included in gross income under section 61(a), which catches all income from whatever source derived except as otherwise provided.

The principle was drawn from different approaches in different cases. In Stanley v CIR,1 where the payments from the Department of Agriculture to dairy farmers who qualified by selling cattle for slaughter at less than their fair market value for dairy purposes were taxable income, the Tax Court held that the payments were not made in exchange for a capital asset because the taxpayer did not give up his goodwill or know-how with respect to the operation of a dairy farm, or the use of the farm, nor did he sell the animals to the government.2 On the other hand, in other cases the courts looked at the purposes of subsidies and the requirements imposed on the taxpayers receiving them. In Helvering v Claiborne-Annapolis Ferry Company3, a subsidy received by a taxpayer for operating a public ferry was held to be taxable income on the grounds that the subsidy paid to the taxpayer for the maintenance of the ferry was actually “earned as were the tolls collected from vehicles and passengers” and that the subsidy “was gain derived from the capital invested in the ferry and the labour involved in its operation”4. Graff v CIR5 followed a similar approach and found that mortgage interest payments made on behalf on the owner of low-income rental housing under section 236 of the National Housing Act were “intended to be a substitute for rent which the taxpayer would otherwise have collected form the tenants”6, and therefore, were taxable income.

In line with judicial decisions, the IRS has treated payments to a cotton exporter under the Agricultural Adjustment Act7, a subsidy to airlines which carry mail, paid in addition to the actual payment for mail carriage8, and a subsidy to ship owners to enable them to meet foreign flag competition9, to be

1 99 TC 259 (1992), aff’d by order, 24 F.3d 249 (1994). 2 Ibid, at 269. 3 93 F,2d 875 (1938). 4 Ibid, at 876. 5 74 TC 743 (1980), aff’d, 673 F.2d 784 (5th Cir. 1982). 6 Ibid, at 753. 7 Rev Rul 68-497. 8 Rev Rul 63-269.

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Appendix B

taxable income. However, subsidies made under legislatively provided social benefit programs for promotion of the general welfare10 and grants made to Indians to expand profit-making Indian-owned economic enterprises on or near reservations11 were excludable from gross income because such payments were in the nature of general welfare.

A grant paid to the taxpayer for the commercialisation of the intellectual property is unlikely to be in the nature of general welfare, and therefore will be included in gross income under section 61(a).

B Taxation of formation of IP spin-off company

B.1 Taxation position on contribution of intellectual property to company

Prima facie, the transfer of the intellectual property to the company in exchange of shares in the company constitutes the disposal of the intellectual property for the consideration of the shares in the company and is caught by section 100112 which deals with the gain or loss on the sale or other disposition of property.

A gain or loss arising from the transfer of the intellectual property may be of a capital nature in the hands of the taxpayer, depending on whether the intellectual property in question constitutes a capital asset under section 1221 (or section 1231 property which is treated like a capital asset).

A “capital asset” includes all classes of property not specifically excluded by section 1221, regardless of how long held13. The question then turns to whether the intellectual property falls within the exclusions of section 1221. Three section 1221 exclusions may be relevant here:

(i) stock in trade, inventory, or property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business;14

(ii) property, used in his trade or business, of a character subject to the depreciation rules in section 167;15 and

(iii) certain copyrights, literary, musical, or artistic compositions and similar properties.16

An amortizable section 197 intangible17 is treated as property which is of a character subject to the depreciation rules under section 167 and, thus, is caught by section 1221(a)(2) exclusion.

9 Ibid. 10 Rev Rul 75-271. 11 Rev Rul 77-77. 12 Unless otherwise specified, sections referred to in this note mean sections in US Internal Revenue Code 1986

(IRC). 13 Reg. Sec1.1221-1(a) 14 Sec1221(a)(1). 15 Sec1221 (a)(2). 16 Sec1221(a)(3). 17 To be an amortizable sec197 intangible, a sec197 intangible must be held in connection with the conduct of a trade

or business or an activity described in sec212. it is noted that sec197 uses the words “held in connection with the conduct of a trade or business” instead of the words “used in the trade or business” which are adopted in sec167 and sec1221(a)(2). It may be due to the unique nature of intangibles. Presumably, they do not have different meanings in substance.

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For the purposes of the following discussion, we assume the intellectual property is NOT stock in trade, inventory, or property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business.

B.2 Patents and know-how

A patent (self-created or acquired18) used in a trade or business is depreciable under section 16719, and is excluded from the definition of “capital asset” under section 1221. Formal processes, designs, patterns, know-how, formats, package designs, and certain computer software20 which are acquired and used in a trade or business constitute amortizable section 197 intangibles, and are not “capital assets”.21 Self-created know-how-like assets abovementioned are not amortizable under section 197, but they may be subject to depreciation allowance under section 167. If, in light of experience or other factors, the useful life of these assets in a business or in the production of income can be reasonably estimated to be a limited period, they may be the subject of a depreciation allowance,22 and hence be excluded from being a capital asset.

Patents, formulas, processes, designs, patterns, know-how, formats, package designs, and computer software that are not used in a trade or business escape the exclusions of section 1221,23 and may amount to capital assets.

B.3 Trademarks, trade names and franchises usually not capital assets

Both self-created or acquired trademarks trade names and franchises which are used in a trade or business constitute amortizable section 197 intangibles and, thus, are not qualified as “capital assets”. The term “trademark” includes any word, name, symbol, or device, or any combination thereof, adopted and used to identify goods or services and distinguish them from those provided by others.24 The term “trade name” includes any name used to identify or designate a particular trade or business or the name or title used by a person or organization engaged in a trade or business.25 The term franchise includes an agreement which gives one of the parties to the agreement the right to distribute, sell, or provide goods, services, or facilities, within a specified area.26 Reading between the lines of these definitions, it seems that a trademark, trade name and franchise can only be held in connection with, or used in a trade or business.

18 Patent acquired after 10 August 1993 is also amortizable under sec197. 19 Reg s1.167(a)-3 refer to patent as the subject of a depreciation allowance provided in sec167. 20 “Computer software” means any program designed to cause a computer to perform a desired function. Such term

shall not include any database or similar item unless the database or item is in the public domain and is incidental to the operation of otherwise qualifying computer software. Sec197 computer software does not include those which is readily available for purchase by the public, is subject to a nonexclusive license, and has not been substantially modified, or those which is not acquired as part of trade or business. See sec197(e)(3) and Reg s1.197-2(c)(4).

21 Sec197(d)(1)(C)(iii) and Reg s1.197-2(b)(5). 22 Reg s1.167(a)-3. 23 Neither depreciation allowance under sec167 nor amortization allowance under sec197 is available to properties

that are not used in a trade or business. 24 Reg s1.197-2(b)(10)(i). 25 Reg s1.197-2(b)(10)(i). 26 Reg s1.197-2(b)(10)(i) and sec1253(b)(1).

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Appendix B

B.4 Copyright assets usually not capital assets

A copyright, a literary, musical or artistic composition, a letter or memorandum, or similar property27 held by a taxpayer whose personal effort created the intellectual property, or by a taxpayer in whose hands the basis of such intellectual property is determined, for the purpose of determining gains from a sale or exchange, in whole or part by reference to the basis of such intellectual property in the hands of the taxpayer whose personal effort created such intellectual property, is subject to section 1221(a)(3) and excluded from being a capital asset. A letter, memorandum, or similar property28 held by a taxpayer for whom such intellectual property was prepared or produced, or by a taxpayer in whose hands the basis of such intellectual property is determined, for purposes of determining gain from a sale or exchange, in whole or part by reference to the basis of such intellectual property in the hands of the taxpayer for whom such intellectual property was prepared or produced, is also excluded: section 1221(a)(3(B).

Except those copyrights acquired with a carryover basis from the transferor, an acquired copyright is not directly excluded by section 1221(a)(3) from the term capital asset. Nevertheless, an acquired copyright that is used in a trade or business is subject to depreciation allowance under section 167 or amortization allowance under section 197, and again, is caught by the exclusion under section 1221(a)(2).

However, an acquired copyright which is NOT used in a trade or business, and does NOT have a carryover basis is likely to avoid all exclusions and to constitute a capital asset.

B.5 Other section 197 intangibles usually not capital assets

Goodwill29, going concern value30, workforce in place, business books and records, operating systems, customer lists, customer-based intangibles31, and supplier-based intangibles32, which are acquired after 10 August 1993 and are used in a trade or business33 qualify as “amortizable section 197 intangibles” and disqualify as capital assets. Licenses or permits granted by governmental unit or an agency or instrumentality, and covenants not to compete are also “amortizable section 197 intangible”, and hence cannot be capital assets. The self-created intangibles exclusion does not apply to them.

27 “Similar property” here includes a theatrical production, a radio program, a newspaper cartoon strip, or any other

property eligible for copyright protection. See Reg s1.1221-1(c)(1). 28 For the purposes of sec1221(a)(3)(B), “similar property” includes a draft of a speech, a manuscript, a research

paper, an oral recording of any type, a transcript of an oral recording, a transcript of an oral interview or of dictation, a personal or business diary, a log or journal, a corporate archive, a drawing, a photograph, or a dispatch. However, “similar property” does NOT include a corporate archive including office correspondence and a financial record, sold or disposed of as part of a going business if such property has no significant value separate and apart from its relation to and use in such business. See Reg s1.1221-1(c)(2).

29 “Goodwill” is the value of a trade or business that is attributable to the expectancy of continued customer patronage, whether due to the name of a trade or business, the reputation of a trade or business, or any other factor. See Reg s1.197-2(b)(1).

30 “Going concern value” is the additional value that attaches to property by reason of its existence as an integral part of an ongoing business activity, including the value attributable to the ability of a trade or business to continue functioning or generating income without interruption notwithstanding a change in ownership, and the value attributable to the immediate use or availability of an acquired trade or business. See s1.197-2(b)(2).

31 It is defined in sec197(d)(2). 32 It is defined in sec197(d)(3). 33 This requirement is automatically satisfied because these properties actually are all business-related.

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B.6 Taxation of gains on transfer of intellectual property assets

If the intellectual property is concluded to be a capital asset, the sale or exchange of the intellectual property generates a capital gain or capital loss. Where the intellectual property is not a capital asset under section 1221, a gain or loss arising from the sale or exchange of the intellectual property may, nevertheless, be capital in nature34 subject to section 1231. Section 1231 gains and losses will be treated as long-term capital gains and losses respectively provided that section 1231 gains are in excess of section 1231 losses in the taxable year.35 Section 1231 gains and losses include any recognized gain or loss from a sale or exchange of section 1231 property respectively.36 Section 1231 property is property used in the trade or business, of a character which is subject the allowance for depreciation under section 167, held for more than 1 year, but excludes the inventory or property held primarily for sale to customers in the ordinary course of the trade or business37: section 1231(b)(1). However, the capital treatment under section 1231 is limited by section 1245 to the extent of the amount of the depreciation or amortization deduction previously allowed/allowable with respect of the intellectual property. That is, generally speaking, if the gain arising from the sale of the intellectual property is greater than the depreciation or amortization deduction previously allowed/allowable with respect of the intellectual property, the amount of the deduction will be treated as ordinary income subject to section 1245(a)(1)and the excess remains capital in nature under section 1231.

If the gain or loss from the transfer of the intellectual property is characterised as capital gain or loss, the taxpayer (transferor) who is an individual, a partnership, a trust, or a limited liability company, (other than corporation) will obtain favourable tax treatment.

B.7 Taxation of contribution of IP assets to a resident company: section 351 - relief

Tax relief is available, if the taxpayer and a third party form a resident company to commercialise the intellectual property, with the taxpayer contributing the intellectual property in for shares and the third party contributing cash in exchange for shares.

Section 351 defers the recognition of gain or loss under section 1001(c) arising from the transfer of the intellectual property provided that criteria set up in section 351 are met. No gain or loss will be recognised on the transfer of property to a (either existing or newly-formed) corporation solely in exchange for stock of the corporation if the transferor(s) is(are) in control of the corporation immediately after the transaction: section 351(a).

Assuming that the resident company is treated as a corporation for tax purposes and is not an investment company within the meaning of section 351(e), other requirements of section 351 need to be examined closely in order to apply section 351. If the company in question is a foreign company, section 351 may not apply to the transfer even if other conditions of section 351 are all satisfied. Generally a foreign company is not considered as a corporation for section 351 purposes: section

34 Sec1231(a), if sec1231 gains for any taxable year exceed the sec1231 losses for such taxable year, sec1231 gains

and losses will be treated as long-term capital gains and capital losses respectively. However, if sec1231 gains do not exceed sec1231 losses for that taxable year, such gains and losses will be treated as ordinary gains and losses respectively.

35 Section 1231(a)(1) 36 Section 1231(a)(3). 37 Inventory or property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or

business is also excluded from sec1221 capital asset. See section 1221(a)(1).

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Appendix B

367(a)(1). But special rules apply if property transferred is intangible property within the meaning of section 936(h)(3)(B). The further requirements are discussed below.

B.7.1 Qualified “property” under section 351

The section 351 relief requires a transfer of “qualified property”.

Both cash38 and intellectual property constitute “property” under section 351.

Certain “know-how” which is not qualified to be intellectual property under intellectual property law may be treated as “property” under section 351 on a case-by-case basis. Generally, this includes anything qualifying as secret process and formulas under section 861(a)(4) or any other secret information as to a device, process, etc., in the general nature of a patentable invention without regard to whether a patent has been applied for and without regard to whether it is patentable in the patent law sense.39 IRS’s emphasis on the nature of “patentable” is inconsistent with the judicial opinion of “secrecy and the right to protect against unauthorised disclosure”40.

After the enactment of section 197 in 1993, it seems that all “section 197 intangibles” are qualified property for the section 351 purposes.41 Following the transfer of the intellectual property, the taxpayer may also provide technical assistance or services to start-up the intellectual property transferred. Apparently services are excluded from “property”42. However, the service that the transferors tender to the transferee corporation may be regarded as part of the transfer of the property, provided that the service tendered is “merely ancillary and subsidiary to the property transfer”43. Whether the services are merely ancillary and subsidiary is a question of fact.

“Property” under section 351 may also include accounts receivable44, regardless of whether the transferor used the cash or accrual method of accounting, as well as section 453 instalment obligations45. A right to receive royalties generating from the intellectual property may be included in “property”.

B.7.2 “Transfer” under section 351

There must be a “transfer” of property to the company to qualify for section 351 relief. The term of “transfer” in section 351 includes not only a “sale or exchange” but also a “transfer of all substantial rights in property”46. A grant of a perpetual exclusive license on a patent constitutes a sale of the patent.47 In line with a judicial opinion that tax law relating to the transfer of patent rights can be applied to tax cases involving transfers of secret formulas and trade names because they are sufficiently similar,48 the IRS treats a perpetual exclusive license of a secret process or other similar

38 IRS Rev. Rul. 69-357 39 IRS Rev Rul 64-56, 1964-1 CB 133. 40 Commercial Solvents Corp. v. Commissioner 42 TC 455 (1964). 41 Sec197(f)(2) says that in the case of any section 197 intangible transferred in a transaction described in sec351 or

721, …, the transferee shall be treated as the transferor for purposes of applying this section… 42 Section 351(d). 43 IRS Rev Rul 64-56, 1964-1 CB 133. 44 IRS Rev. Rul. 80-198, 1980-2 CB 113. 45 Reg. Sec1.453-9(c)(2) 46 IRS Rev Rul 64-56, 1964-1 CB 133. 47 Commercial Solvents Corp. v. Commissioner 42 TC 455 (1964), at 468. 48 J.H. Pickren v. United States 378 F.2d 595 (1967), at 599.

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qualified secret information as a transfer of property under section 351.49 On the other hand, even a non-exclusive license could amount to a transfer under section 351. 50

In the DuPont case where the taxpayer granted to its subsidiary a non-exclusive royalty-free license to make, use and sell products under certain patents and gave up its right to asset patent infringement against the subsidiary’s products, the court held that there was a mutual exchange where the taxpayer granted a non-exclusive license which was perpetual, irrevocable, quite substantial in value and, received of stock in return.51 The court also held that section 351 did not embody the same notions as the capital gains provisions, that is, the term of “transfer” in section 351 is not confined by the requirement of full disposition as a precondition to a “sale or exchange” in capital gains provisions, because the underlying principle for section 351 was the continuity of control and, in contrast, the one for the capital gains provisions was the complete divestiture of ownership interests.52

B.7.3 “Solely” for “stock”

To obtain section 351 relief, intellectual property or cash transferred to the resident company must be transferred solely in exchange for stock in the company.

If the taxpayer transfers intellectual property in exchange for stock in the company and other property53, the word “solely” will limit the non-recognition treatment to the gain or loss arising from the stock, that is, a taxable gain will be recognized to the extent of the amount of money received or the market value of the property received and no loss will be recognized to the taxpayer.54

Certain nonqualified preferred stock are not treated as stock but as “other property”.55 Generally speaking, this concerns preferred stock56 that is subject to a redemption right or obligation within 20 years or has an dividend rate that references interest rates or an equivalent index. The term of “stock” in section 351 also excludes stock rights and stock warrants.57 However, contingent stock may be treated as stock for the purposes of section 351.58

In the Hamrick case the taxpayer transferred a patentable invention to a controlled corporation in exchange for stock plus a contingent right to receive additional stock dependent on the performance of the corporation. The court held that contingent stock constitutes stock under section 351 and that the contingent stock holder possessed either stock or nothing at all. The court distinguished contingent stock from stock warrants on the grounds that the stock warrants holder had only an option to purchase stock at a fixed price, while the contingent stock holder was immediately entitled to all reserved stock without any positive action or further consideration.59 However, the IRS expressed the opinion that it would follow the Hamrick decision on the different grounds, that the contingent rights received by the

49 IRS Rev Rul 64-56, 1964-1 CB 133. 50 E I DuPont de Nemours and Co v United States 471 F.2d 1211 (Ct. Cl. 1973). 51 Ibid, at 1219. 52 Ibid, at 1214-1217. 53 For example, money, debt instrument, or assumption of liabilities to repay transferor’s debts. 54 Section 351(b) 55 Section 351 (g) 56 “Preferred stock” defined in sec351 (g)(3) means stock that is limited and preferred as to dividends and does not

participate in corporate growth to any significant extent. The taxpayer probably can avoid the application of sec351(g) by designing a class of shares which either is not limited or is not preferred. See Howard E Abrams and Richard L Doernberg, Federal Corporate Taxation, New York: Foundation Press, 1998, at p32.

57 Reg. Section 1.351-1(a)(1). 58 Hamrick v. Commissioner 43 TC 21 (1964); Rev. Rul. 66-112, 1966-1 CB 68. 59 43 TC 21 (1964), at 33.

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Appendix B

taxpayers were not specifically assignable and not readily marketable and that they could only give rise to the receipt of additional stock by one who was a party to the transfer.60

B.7.4 Control test under section 351

In order to apply section 351, the taxpayer(s) who transfer(s) the property to a corporation in exchange for stock of the corporation must control the corporation immediately after the transfer.

The term “control” defined in section 368(c) means the ownership of stock possessing at least 80 percent of the total combined voting power of all classes of stock entitled to vote and at least 80 percent of the total number of shares of all other classes of stock of the corporation.61 In calculating “80 percent”, “nonqualified preferred stock” counts as stock.

The “control” requirement aims to ensure the sufficient continuity of ownership interests, that is the rationale of section 351. However, the “80 percent” test itself is somewhat arbitrary and controversial.62

Apart from the “80 percent” test, two issues need to be identified: a group of transferors and control “immediately after” the transfer. It seems not hard to identify, in the IP spin-off company scenario, that the taxpayer who transfers intellectual property and the third party who transfers cash to the spin-off company are a group of transferors and that they own 100 percent of the stock in the newly-formed resident company immediately after the transfer. Accordingly, the control requirement in section 351 will be satisfied.

However, the taxpayer and the third party need to carefully structure the transaction to avoid being disqualified from section 351. Where there is a prearranged binding agreement to sell over 20 percent of (either voting or nonvoting) stock received by them to other parties, it is very likely that the transfers of intellectual property and cash and the prearranged sale agreement will be deemed to be one single transaction and the transferors of intellectual property and cash will be deemed to never actually meet the control requirement. 63 If there is no such agreement, but a disposal of stock received by the taxpayer or the third party occurs or additional stock is issued, other factors will be considered: the intent of the parties, the time element and the pragmatic test of the ultimate, and the mutual interdependence of each steps.64

B.7.5 Conclusion as to section 351 relief

It appears that all the elements of section 351 are found to apply to formation of an IP spin-off company, as analysed above:

(a) the intellectual property transferred is “property”; 60 Rev. Rul. 66-112, 1966-1 CB 68 61 In Rev. Rul. 59-259, 1959-2 CB 115, IRS ruled that while classes of voting stock can be combined in applying the

80 percent test, each class of nonvoting stock must satisfy the 80 percent test. 62 Howard E Abrams and Richard L Doernberg, Federal Corporate Taxation, New York: Foundation Press, 1998, at

p.39. 63 American Bantam Car Co. v. Commissioner 11 TC 397 (1948), at pp405-406. See also Rev. Rul 79-70, Rev. Rul.

79-194 and Rev. Rul. 84-44. 64 American Bantam Car Co. v. Commissioner, 11 TC 397 (1948), at p 405. See also McDonale’s Restaurants of Ill.,

Inc. v. Commissioner, 688 F.2d 520 (7th Cir. 1982), at pp524-525; Kamborian v. Commissioner 469 F.2d 219 (1972), at pp221-222; D’Angelo Associates, Inc. v. Commissioner, 70 TC 121 (1978).

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(b) the intellectual property is sold or a perpetual exclusive license on the intellectual property is granted, to the resident company;

(c) in return, the taxpayer and the third party receive only stock (which is not non-qualified preferred stock);

(d) the taxpayer and the third party own 100 percent of stock in the resident company immediately after the transfer and no other related agreements exist, and so the control test is met.

Accordingly section 351 will apply to the taxpayer and the third party, and no gain or loss will be recognised on the transfer of intellectual property and cash to the resident company.

We also note that section 1032 provides non-recognition relief to the resident company on the exchange of stock for property. To some extent65, section 1032 is the counterpart at the corporation level to section 351.

B.7.6 Basis of the intellectual property in hands of spin-off company

We then need to consider the basis (cost base) of the intellectual property in the hands of the resident company and the basis of stock in the hands of the taxpayer.

Section 358(a) provides the taxpayer with a basis in stock equal to the basis of the intellectual property and section 362(a) carries over the basis of intellectual property in the hands of the taxpayer to the resident company, provided that no gain has been recognised to the taxpayer on the transfer of the intellectual property. (Allocation of basis among different classes of stock is not considered here.)

The general rules for basis of property can be found in section 1011, section 1012 and section 1016. However, it is not clear-cut that the word “basis” used in section 358 and section 362 refers to the meaning of “the basis” in section 1012 or to the meaning of “the adjusted basis” in section 1011 and section 1016. Sections 722 and 723 in partnership provisions that are counterparts of section 358 and section 362 on similar non-recognition treatment adopt the term of “the adjusted basis”. The confusion may be clarified by the illustrating example in Reg. Section 1.358-1(b) which uses “the adjusted basis” in applying section 358.

The question will then turn to what is the adjusted basis of the intellectual property in the hands of the taxpayer. It will be the basis of the intellectual property determined under section 1012 adjusted as provided in section 1016: section 1011(a). The basis of property is its cost66 that is the amount paid for such property in cash or other property: section 1012 and Reg. Section 1.1012-1(a). In calculating the adjusted basis of property, the basis of property must be increased by the amount of any expenditure or other item properly chargeable to capital account67, such as the cost of any improvements made to property that has a useful life of more than one year, and be decreased by any amount of allowed deduction68, including deferred research and experimental expenses under section 174(b)(1)69 and amounts of depreciation and amortization under section 167 and section 197.70

65 Section 1032 applies to a transaction even if the transaction is not governed by section 351. 66 The cost of property includes debt obligations, personal services rendered, settlement fees and closing costs, such

as purchase and selling commissions, legal fees, title insurance, surveys, transfer taxes etc. 67 Section 1016(a)(1) and Reg. Section 1.1016-2. 68 The basis of property must be subtracted by the amount of allowed deduction or allowable deduction whichever is

greater.

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Appendix B

B.8 Treatment of costs associated with IP

Generally speaking, expenditures paid or incurred in creating or acquiring an asset must be capitalized under section 263 provided they result in the realization of benefits beyond the current taxable year. In a leading case INDOPCO, Ino. V CIR71 where the taxpayer’s claim to deduct certain legal and investment banking fees incurred in the course of a friendly takeover was denied, the Supreme Court held that “deductions are exceptions to the norm of capitalization”72 and that the determination of whether certain expenditures may be currently deducted or capitalized “envisions an inquiry into the duration and extent of the benefits realized by the taxpayer”73. The Court also acknowledged “…the mere presence of an incidental future benefit – some future aspect – may not warrant capitalization…”.74 The “future benefit” concept results in certain confusion and Reg s1.263(a)-4 clarifies this confusion to some extent by providing rules concerning capitalisation of amounts paid to acquire or create intangibles.

B.8.1 Acquired assets

An amount paid to acquire any intangible from another party in a purchase or similar transaction must be capitalized75 and is not currently deductible under section 162. Reg s1.263(a)-4(1) enumerates76 various qualified intangibles including patents, copyrights, franchises, trademarks, trade names, and goodwill. The amount paid to acquire an asset can be made in cash, debt obligations, personal services, or other property paid, credited, or agreed to paid or given for the purchased intellectual property.77 In addition, certain transaction fees are also required to be capitalized if the amount is paid in the process of investigating or otherwise pursuing the transaction.78 As a result, the amount paid to purchase the intellectual property plus the transaction fees will be the basis of the intellectual property under section 1021.

If the intellectual property is a section 167 depreciable asset or a section 197 amortizable asset, the adjusted basis of the intellectual property will be the amount of the basis of the intellectual property reduced by any allowable or allowed deductions, whichever is greater, under section 167 or section 197.79

B.8.2 Self-created assets

The taxpayer must capitalize amounts paid to create an intangible described in Reg s1.263(a)-4(d). However, Reg s1.263(a)-4(d) does not explicitly mention those intangibles aforesaid in Reg s1.263(a)- 69 Section1016(a)(14). 70 Section 1016(a)(2) . 71 503 US 79 (1992). 72 Ibid, at 84. Note that Reg s1.263(a)-4(b)(4) also provides that “nothing in this section changes the treatment o fan

amount that is specially provided for under any other provision of the IRC (other than section 162(a) and 212) or the regulations thereunder”. Section 162 is the general expenditures deduction provisions.

73 Ibid, at 88. 74 Ibid, at 87-88. 75 Reg section 1.263(a)-4(c)(1). 76 This list is nonexclusive. Presumably, it also applies to other sec197 intangibles. 77 Federal Tax Coordinator (2nd Ed), P-1119. 78 Reg section 1.263(a)-4(b)(1)(v) and (e)(1)(i). However, de minimis costs and employee compensation are not

treated as transaction costs. “de minimis costs” means amounts paid in the process of investigating or otherwise pursuing a transaction if , in the aggregate, the amounts do not exceed $5,000. See Reg section 1.263(a)-4(e)(4).

79 Section 1016(a)(2).

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4(c), such as patents, copyrights, franchises, trademarks, and trade names. Nevertheless, these intangibles may satisfy the “separate and distinct intangible asset” test and the amount paid to create or enhance a separate and distinct intangible asset should also be capitalized. The term “separate and distinct intangible asset” means a property interest of ascertainable and measurable value in money’s worth that is subject to protection under applicable State, Federal or foreign law, and the possession and control of which is intrinsically capable of being sold, transferred or pledged separated and apart from a trade or business. However, the Regulation does not provide useful guidance with respect to capitalizing costs incurred in creating a patent, copyright or a trademark.

B.8.3 Patents and know-how

The expenditures incurred in creating a patent by the taxpayer in connection with his trade or business may be currently deductible, or may need to be amortised as deferred expenses under section 174 concerning research and experimental expenditures. The term “research and experimental expenditure” means expenditures incurred in connection with the taxpayer’s trade or business which represent research and development costs in the experimental or laboratory sense. It generally includes all such costs incident to the development or improvement of a product, and the costs of obtaining a patent, such as attorneys’ fees expended in making and perfecting a patent application.80 Section 174 applies to research and experimental expenditures incurred on a pilot model, process, formula, invention, technique, or similar property.81 Section 174 expenditures cover costs paid or incurred by the taxpayer for research or experimentation undertaken directly by him, and for research or experimentation carried on in his behalf by another person or organisation.82 As noted above that the application of section 174 will not affected by section 263, the amounts deductible under section 174 are not required to be capitalised.

The Regulations does not give examples of costs which are qualified as research and experimental expenditures, but in Reg. section 1.174-2(a)(3) expressly excludes from research and experimental expenditures certain expenses, such as expenditures for the ordinary testing or inspection of materials or products for quality, efficiency surveys, management studies, consumer surveys, advertising or promotions, the acquisition of another’s patent, model, production or process, and, research in connection with literary, history, or similar projects. The example in Reg s1.174-2(b)(4) illustrates that the costs of material or labour used in the construction, installation, acquisition, or improvement of a product are also excluded.

If another party challenges the taxpayer’s title to a patent, an amount paid to that other party to defend or perfect title to the patent must be capitalised under section 263.83 The taxpayer also has to capitalise amounts paid to a governmental agency to obtain, renew, renegotiate, or upgrade its rights under certain intangibles, such as trademark, trade names copyright, licence, or franchise.84 Interestingly, the Regulation does not mention patents, or know-how. Probably it considers that such costs incurred in respect of a patent or know-how would be generally deductible under section 174.

The expenditures capitalised and chargeable to capital account constitute the basis of the patent. Depreciation deductions may be allowable under section 167 with respect to the self-created patent

80 Reg section 1.174-2(a)(1). 81 Reg section 1.174-2(a)(2). 82 Reg section 1.174-2(a)(8). 83 Reg section 1.263(a)-4(d)(9)(i). 84 Reg section 1.263(a)-4(d)(5)(i).

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Appendix B

and the basis of the patent should be reduced by the amount of the depreciation deduction allowable or allowed, whichever is greater.

On the other hand, if the patent is not created in connection with the taxpayer’s trade or business, no section 174 or section 167 deduction is available and the costs incurred in creating the patent will be capitalised under section 263.

B.8.4 Trademarks and trade names

As far as a trademark or trade name are concerned, the distinctions between expenditures currently deductible under section 162 as ordinary business expenses, and expenditures which are incurred in generating future benefits and have to be capitalised under section 263, are rather confusing. Many routine business expenses engender not only current benefits but also future benefits which are attributable to the trademark. Although INDOPCO construed capitalisation under section 263 as the rule and current deductibility as the exception, there is no doubt that ordinary business and necessary business expenses are deductible under section 162. Then IRS considered the recurring nature of expenses as an important factor in determining whether the expenses may be deducted or must be capitalised.85 The taxpayer is obliged to capitalise the amounts paid to a governmental agency to obtain, renew, renegotiate, or upgrade its rights under the trademark,86 and the amounts paid to another party to defend or perfect title to the trademark if that other party challenges the taxpayer’s title to the trademark.87

Since a self-created trademark is amortizable under section 197, the adjusted basis of the trademark is the amount of the basis of the trademark minus amortization deduction allowable or allowed under section 197 whichever is greater.

B.8.5 Copyright

The research and experimental expenditures incurred in creating a copyright may not be deductible under section 174 if such a research is in connection with literary, historical or similar projects.88 And these expenditures will be capitalised under section 263A.89 Section 263A capitalizes certain direct and indirect costs incurred in producing personal tangible property. Generally “personal tangible property” does not include intangible property, but it includes films, sound recordings, video tapes, books, and other similar property embodying words, ideas, concepts, images, or sounds.90 The amounts paid to a governmental agency to obtain, renew, renegotiate, or upgrade rights under the copyright,91 and the amounts paid to another party to defend or perfect title to the copyright92 must be capitalised under section 263.

85 Rev Rul 89-23, 1989-1 CB 85. 86 Reg section 1.263(a)-4(d)(5). 87 Reg section 1.263(a)-4(d)(9). 88 Reg section 1.174-2(a)(3)(vii). 89 Reg section 1.174-2(a)(5). 90 Reg section 1.263A-2(a)(2)(i) and (ii). Section 263A applies to tangible personal property defined in section

263A(a)(2) without regard to whether such property is treated as tangible or intangible property under other sections of the IRC.

91 Reg section 1.263(a)-4(d)(5) 92 Reg s1.263(a)-4(d)(9)

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Like a patent, a self-created copyright is not amortizable under section 197 but may be depreciable under section 167. The adjusted basis of the self-created copyright is equal to the amounts of capital expenditures less the amount allowable or allowed under section 167.

C Taxation of formation of a partnership

The section governing contributions of intellectual property assets and cash to a partnership is section 721.

C.1 Section 721 relief

Section 721 defers a recognition of gain or loss on contributions of property to a partnership (either existing or newly-formed)93 in exchange for a partnership interest. The non-recognition treatment applies to both a partnership and its contributing partners. The basis of an interest in the partnership acquired by the contributing partner is an amount equal to the adjusted basis in the hands of the contributing partner, of any property contributed plus any cash contributed: section 722. The basis of the property contributed in the hands of the partnership is the adjusted basis of that property to the contributing partner at the time of the contribution, provided that no gain is recognised to the contributing partner94: section 723.

C.2 Meaning of “contribution”

Although section 721 is silent on the scope of “contribution”, certain lines must be drawn when considering the application of section 721(a): contribution and sale; contribution and license. In Reg. 1.721-1, IRS ruled that section 721 may not apply where a partner sells property to the partnership. If by transferring the intellectual property the taxpayer receives money or other consideration other than an interest in the partnership, such a transfer will be treated as a sale of the intellectual property to the partnership which is subject to section 707. Section 721 also does not apply where a partner may allow the partnership to use property without transferring the ownership of property.

Section 351 governing the transfer of property to a corporation for its stock, is analogous to section 721. Notwithstanding that the application of section 351 has an extra requirement of “control immediately after the transfer”, the IRS hold the view that the standards for an exchange of property for purposes of section 721 and section 351 are similar. The IRS accepts the principle in DuPont95 case and applies it to both a “transfer” under section 351 and a “contribution” under section 721.96 Hence, both exclusive and nonexclusive licences of intellectual property may constitute a “contribution” of intellectual property under section 721.

93 Reg. 1.721-1(a). 94 Gain or loss will be recognised on such contribution if the partnership would be treated as a investment company

under sec351(e)(1). 95 E I DuPont de Nemours and Co v United States 471 F.2d 1211 (Ct. Cl. 1973). 96 2001 TNT 218-46. (Tax Notes Today).

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C.3 Meaning of “property”

Section 721 itself does not impose any requirement on the term of “property”. The term “section 197 intangibles” is helpful here, as it is under section 351. Patents, unpatented know-how97, copyrights, franchises, trademarks, trade names and goodwill98 are taken to be “property” for section 721 purposes. If the intellectual property in the present case was acquired by the taxpayer from a third party, it is clear that the intellectual property will be “property” for section 721 purposes.

However, where the intellectual property was created by the taxpayer (with his or her personal efforts99), the IRS may argue that the partnership interest is received by the taxpayer for services he or she rendered rather than for the intellectual property (self-created intangible property) and hence it is necessary to distinguish services-generated intangible property from services rendered. The leading cases on this point are United States v Frazell100 and United States v Stafford101. Although both cases were remanded by the Court of Appeals because of insufficient evidence, the Court did give guidance on whether a contribution of an intangible asset to a partnership could be covered by section 721. The court in Frazell identified the oil maps used in providing services as a separated property qualified for section 721 and held that non-recognition treatment under section 721 could apply to the joint venture interest received in exchange for the oil maps used in rendering services if the taxpayer has transferred the ownership of the oil maps to the joint venture. In Stafford where the taxpayer exerted personal effort to obtain on his own behalf from an insurance company “letter of intent” for a lease and loan commitment on very favourable terms, and transferred the letter of intent to a limited partnership in exchange for a partnership interest, the court found the non-enforceable letter of intent, which is analogous to goodwill and unpatented know-how, encompass sufficient bundle of rights to constitute “property” within the meaning of section 721.102

C.4 Problems with services

Although, unlike section 351, section 721 does not expressly keep services rendered for a partnership interest out of the scope of section 721, the courts in the cases above affirmed that section 721 does not apply to a partnership interest received in exchange for services rendered if the facts in each case evidenced that the receipts of the partnership interests is not for those intangible properties but for services rendered. Reg. 1.721-1(b)(1) also rules that non-recognition treatment under section 721 is not applicable to an interest in a partnership capital103 received for services rendered and that the fair market value of such a partnership interest is assessable under section 83 provided such interest is not subject to a substantial risk of forfeiture104.

It should be noted that Reg. 1.721-1 concerns only a partnership capital interest in exchange for services rendered and it talks nothing about an interest in partnership profit, as was received for

97 IRS Rev. Rul. 64-56. 98 IRS Rev. Rul. 70-45 99 There is actually no difference on whether the taxpayer is an individual or a company. 100 335 F.2d 487 (5th Cir.1964). 101 727 F.2d 1043 (11th Cir. 1984). 102 Ibid, at 1052. 103 Rev Proc. 93-27 defined a capital interest as an interest that would give the holder a share of the proceeds if the

partnership’s assets were sold at fair market value and then the proceeds were distributed in a complete liquidation of the partnership and, a profits interest as a partnership interest other than a capital interest.

104 In other words, where any substantial conditions or restrictions constrain the recipient’s realization of such interest, no amount need be included until those restrictions terminate.

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services in Diamond v Commissioner105. In Diamond where the profits interest received for past services was easily valued and was sold shortly after the receipt, the Court of Appeals held that the receipt of a profits interest with determinable market value in a partnership is taxable income.

The principle in Diamond was followed by a recent case Campbell v Commissioner106. In Campbell, the Court agreed that the non-recognition principles of section 721 do not apply to a service partner because a service partner does not contribute property in exchange for his partnership interest.107 Nevertheless, a substantial distinction was recognised between the receipt of a capital interest in a partnership for services rendered and the receipt of a profits interest for services.108 Distinguishing the facts in Campbell, from those in Diamond, the Court took the views that a profits interest in a partnership without fair market value at the time it is received is not includable in the recipient’s income in the tax year of the receipt and that any predictions on the partnership’s ultimate success and profits are speculative.109

Following Campbell and Diamond, IRS issued Rev Proc 93-27 announcing that the receipt of a profits interest in a partnership for the provision of services to or for the benefit of a partnership is not treated as a taxable event, unless:

(a) the partnership’s profits are derived from a substantially certain and predictable stream of income, such as from high quality debt or a net lease;

(b) the profits interest received is disposed within two years of its receipt; or

(c) the interest is a limited partnership interest in a publicly traded limited partnership as defined in section 7704(b).

Rev Proc 2001-43 went on to consider the tax treatment of the receipt of substantially non-vested110 profits interests in return for services, which is addressed in Rev. Rul. 93-27. The receipt of such an interest will neither be taxable upon the receipt nor upon the date that the interest substantially vests, on the condition that the recipient is treated as a full partner for tax purposes111.

C.5 Anti-avoidance rules

A contribution made by a non-resident partner also falls out of the application of section 721(a) and IRS is authorised to allocate gains to such contributing partner: section 721(c). Where a resident partner contributes an intangible asset to a non-resident partnership in exchange for a partnership interest, such contribution will be deemed to be a sale of the intangible asset and hence be excluded from the application of section 721(a): section 721(d) and section 367(d)(3).

Even if all the requirements set up in section 721 and its regulations are met, non-recognition treatment may be unavailable to the formation of a partnership if it is caught by the anti-abuse rules in

105 492 F.2d 286 (7th Cir.1974). 106 943 F.2d 815 (8th Cir.1991). 107 Campbell v Commissioner 943 F.2d 815, at p821. 108 Ibid, at p822. 109 Ibid, at p823. 110 If the interest is subject to a substantial risk of forfeiture and is nontransferable: Reg. 1.83-3(b). 111 The recipient takes into account his or her distributive share of partnership’s income, gain, loss, deduction and

credit in computing his or her income tax liability; and no deduction related to the fair market value of the interest has been claimed as wages or compensation for services.

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Reg. 1.701-2. Where a partnership is formed or availed of with a principal purpose to reduce substantially the present values of the partners’ aggregate federal tax liability in a manner inconsistent with the intent of the partnership provisions, the Commissioner can reallocate the tax liabilities to achieve the appropriate tax results.112

C.6 Conclusions

If section 721 is triggered in the case of a contribution of intellectual property assets to a partnership to form a commercialisation venture, neither gain nor loss is recognised to the taxpayer and the partnership upon the contribution of the intellectual property to the partnership. The adjusted basis of the intellectual property in the hands of the taxpayer will be carried over to be the basis of the intellectual property for the partnership and the basis of the partnership interest for the taxpayer.

D Taxation of formation of a resident limited partnership113, a resident limited liability partnership114, or a resident limited liability company

There are no separate provisions stipulating tax treatments for a formation of a limited partnership, limited liability partnership (LLP) or limited liability company (LLC). A business entity with two or more members115 is classified for federal tax purposes as either a corporation or a partnership, and the term “business entity” broadly covers any entity which is not a trust or otherwise subject to special treatment for tax purposes.116 Thus, the essential issue for formation of such entities is the classification of a limited partnership, LLP and LLC.

According to section 7701(3) and Reg. Section 301.7701-2(b), “corporation” includes any business entity organised as a corporation under relevant state or federal law, an association and a joint-stock company (for the purpose of this sub-Q). Under the “Kintner” regulations (a previous version of Reg. Section 301.7701-2, prior to 1997), six criteria were taken into account for distinguishing corporations from other entities: (1) the presence of associates; (2) an objective to carry on business and divide the gains therefrom; (3) continuity of life; (4) centralisation of management; (5) limited liabilities; and (6) free transferability of interests. To be classified as a corporation, the entity must have had more corporate than non-corporate characteristics.

Under section 7701(a)(2), “Partnership” includes a syndicate, group, pool, joint venture, or other unincorporated organization, through or by means of which any business , financial operation, or venture is carried on, and which is not, a trust or estate or a corporation.

112 Reg. 1.701-2(b). 113 Limited partnership is a partnership with at least one general partner and at least one limited partner whose liability

is limited to his contribution and who cannot participate in the management. They are formed under limited partnership laws of each state.

114 Limited liability partnerships (LLPs) are usually used by professionals such accountants or lawyers. An LLP is a general partnership in which each individual partner remains liable for his or her own malpractice and the liabilities arising out of the wrongful acts or omissions of those over whom the partner has supervisory duties. See US Master Tax Guide, NY: Commerce Clearing House (CCH), 2004, at p159.

115 A business entity with only one owner is classified as a corporation or is disregarded (default). 116 Reg. Sec301.7701-2(a).

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Generally, if a business entity does not fall within the meaning of a “corporation” under Reg. Section 301.7701-2(b)(1) or (3) to (8)117, it can elect to be treated as an association that actually receives corporate tax treatments (under Reg. Section 301-7701-2(b)(2)) or a partnership for federal tax purposes: Reg. Section 301.7701-3(a). Resident limited partnerships, LLPs and LLCs do not fall within any categories of entities described in Reg. Section 301.7701-2(b)(1) and (3) to (8), and hence are entitled to choose corporate tax treatments or partnership tax treatments. Limited partnerships, LLPs and LLCs need to file an election only when they want to be taxed as an association. Otherwise, newly-formed limited partnerships, LLPs and LLCs (with at least two members) will automatically be treated as a partnership for federal tax purposes under the default rules in Reg. section 301.7701-3(b).

An exception to the classification rules abovementioned is that certain “publicly traded partnerships” caught by section 7704 are treated as corporations unless 90% or more of their gross income is derived from qualifying passive income118 sources: section 7704 (a) and (c). “Publicly traded partnership” means any partnership if interests in such a partnership are traded on an established securities market, or are readily tradeable on a secondary market: section 7704(b). Section7704 actually only applies to limited partnerships, LLPs and LLCs as under state law general partnership interests cannot be traded.119

A separate partnership or corporation can not be identified if the relationship between the parties is an employment, agency or independent contractor arrangement.

Hence, depending on their election, the limited partnership, LLP and LLC will be taxed on formation as either a formation of a corporation or formation of a partnership. These tax treatments have been outlined at B and C above.

E Taxation of formation of an unincorporated joint venture

An unincorporated joint venture may be classified as partnership within the definition of “partnership” under section 7701(a)(2) provided that the participants of the joint venture carry on a trade, business, financial operation, or venture and divide the profits therefrom. However, a joint undertaking merely

117 (1) a business entity organized under relevant law as incorporated or as a corporation, body corporate, or body

politic; (3) a joint-stock company or a joint-stock association; (4) an insurance company; (5) a State-chartered business entity conducting banking activities; (6) a business entity wholly owned by a state; (7) a business entity that are taxable as corporations under a provision of IRC other than sec7701(a)(3); and (8) certain organizations formed under the laws of a foreign jurisdiction.

118 They are enumerated in section 7704(d), including interest, dividends, real property rents, gain from the disposition of real property, mining and natural resource income, etc.

119 P R McDaniel, M J McMahon, Jr & D L Simmons, Federal Income Taxation of Business Organizations (3rd ed), NY: Foundation Press, 1999, p.13.

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Appendix B

to share expense or mere co-ownership of property that is maintained, kept in repair, and rented or leased does not constitute a separate entity and hence not a partnership. 120

If the unincorporated joint venture constitutes a partnership, the tax treatment on formation will be as C above.

120 Reg. Sec301.7701-1(a)(2).

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Appendix C

Taxation of Employee Stock Options in Start-up Intellectual Property Firms :

A Comparison of US Treatment and Australian Treatment

Lillian Hong

This Appendix reviews the tax treatment of employee stock options under US tax law and contrasts the treatment under Australian tax law in the context of start-up companies commercialising intellectual property. The United States has a more friendly tax environment for using employee stock options.

It finds that the employees are encouraged to retain ownership in companies’ stock options and stock in return for deferral of tax liability and favourable ‘capital gains’ tax treatment. In Australia, a deferral concession is available for certain ‘qualifying’ employee share options, but not “capital gains” treatment. In addition, requirements imposed on the qualifying options are stiffer and the concessional treatment is less favourable than under US tax law.

A Introduction

Employee stock options have been widely used in the United States as a form of executive compensation in the past decade. The total grant-date value1 of employee stock options granted in S&P 500 firms has increased dramatically from US$11 billion in 1992 to US$119 billion in 2000.2 It then fell to US$71 billion in 2002, but that was still over 6 times the value in 1992.3 The decline in value was largely due to the falling stock market. Its popularity continues to grow, especially in sunrise start-up companies where non-managerial employees are also compensated by employee stock options.4 The use of employee stock options has been a source of controversy in tax law, accounting rules and corporate governance for the past two decades.5

A.1 Benefits of stock options

Studies have identified several ‘arguable’ benefits for employers as well as employees to use stock option compensation.

1 The option values are in 2002-constant dollars and are based on Compustat’s ExecuComp data. 2 Brian J. Hall & Kevin J Murphy, ‘The Trouble with Stock Options”, Summer 2003, 17(3) Journal of Economic

Perspectives 49-70, at p.49. 3 Ibid. 4 Levmore, Saul (2001) “Puzzling Stock Options and Compensation Norms”, 149 University of Pennsylvania Law

Review 1901, at p.1901. 5 See Michael W Melton, ‘The Alchemy of Incentive Stock Options - Turing Employee Income into Gold”, April

1983, 68 Cornell Law Review 488; Calvin H Johnson, ‘Stock Compensation: The Most Expensive Way to Pay Future Cash’, Spring 1999, 52 SMU Law Review 423; David I Walker, ‘Is Equity Compensation Tax Advantaged?’, June 2004, 84 Boston University Law Review 695.

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Appendix C

(a) First, in addition to the stock options, employees also receive favourable tax treatment. Employees may be able to defer tax to the time of disposal of the underlying stock in respect of certain employee stock options (referred to as ‘statutory options’ in US tax law) and convert ordinary income into capital gains. In the United States, a long-term capital gain6 is taxed at a capital gains tax rate of 15% for individuals in the 25% or above tax bracket (5% for individuals in the 10% or 5% tax bracket).7

(b) Second, under the current accounting practice8, many companies do not expense the cost of employee stock options in their financial statements.9 However, in December 2004 the United States Financial Accounting Standards Board (FASB) issued the finalised statement (FAS 123R) on share-based payments which requires all the companies to expense the grant-date value of stock options from 15 June 2005.10 Nevertheless, these new rules are facing stiff opposition, especially from the sunrise industry.11

(c) Third, thanks to the favourable tax treatment and potential high return from stock options, the use of stock options in lieu of cash compensation is a useful way to attract and retain highly motivated and talent executives and key technical employees.

(d) Fourth, stock options align the interest of executives and other key employees with that of shareholders and mitigate problems with executive risk aversion, both features which should eventually improve the firms’ performance. However, this proposition has been criticized after the accounting scandals at Enron, WorldCom and other companies that were linked to excessive risk taking which was said to be caused by the escalation in option grants.12

A.2 Stock options in sunrise industry companies

Sunrise industry start-up companies13 commonly face significant cash-flow constraints. They are unable to offer competitive cash-based compensation packages to the executives and other key employees. Equity-based compensation is, no doubt, an effective way to save cash. By granting stock options or stock to the employees, the company has not promised to make any cash payment,14 but has committed part of its future cash to the employees.

6 A capital gain from the sale of a capital asset that has been held for more than 12 months. See section 1(h) IRC. 7 Section 1(h) IRC. 8 APB Opinion No. 25. 9 FASB recommended in FAS 123 that companies expense the fair market value of stock options granted. 10 Carrie Johnson, ‘FASB Orders Options Counted as Expenses; Lobbyists Look to Head Off Plan’, Financial Section

(E01), The Washington Post, 17 December 2004. 11 Donna Block, ‘Stock Options fight Rages On’, Daily Deal, 14 January 2005. 12 Brian J. Hall & Kevin J Murphy, above n 2, pp49-50. 13 The terms ‘sunrise industry’ and ‘sunrise enterprise’ are used in Shared Endeavours, a report by House of

Representatives Standing Committee on Employment, Education and Workplace Relations. A ‘sunrise industry’ is knowledge intensive, in an emerging area of the economy and commercialising recently developed technology and/or research and development outcomes. A ‘sunrise enterprise” is a small or medium size company that is less than 5 years old and operates in a sunrise industry and/or is relying on venture capital.

14 Dividend distributions or share buyback is under the discretion of the board of directors, but not the discretion of shareholders.

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Taxation of employee stock options in start-up intellectual property firms A comparison of US treatment and Australian treatment

For the issuer company, stock is a proxy for the future cash that will need to be paid out on the stock.15 It represents the discounted present value of cash distributions.16 The use of stock options to compensate employees also helps, in some sense, to attract venture capital and other investments. Stock options, as a form of contingent compensation, places executives’ and key employees’ interests and risks in line with those of venture capitalists and other investors. It diminishes the incentive for the founders of the start-ups (who are usually executives and key employees) to overestimate the merits of their ideas.17 Thus it increases the credibility of the success of their ideas and reduces the information costs to the investors18.

On the other hand, the substantial high-growth potential in sunrise start-ups amplifies the incentive function of the equity-based compensation, i.e. to attract and retain executives and key employees. Nevertheless, although the sunrise start-ups have high growth potential, they also involve high risks. Thus stock options could be worthless if the companies fail. The deferral of tax liabilities on stock option compensation is another important incentive in offsetting the risk effect, avoiding taxing employees on their “risky” paper gains. The incentive effect of stock options depends on stock prices, which are ultimately determined by the firms’ performance and the market. But the government can temporarily ‘give up’ some tax revenue by deferring tax on stock options to foster sunrise start-ups and to encourage economic growth.

A.3 Types of stock options

The employee stock options are rights granted to employees to buy stock in the employer company at a pre-specified ‘exercise’ price within a pre-specified period of time. There are no specific rules governing the model of employee stock option arrangements in the United States although state corporate laws, securities rules, the tax code and accounting rules may require shareholder approval and disclosure, particularly for public companies. But these requirements are less important for start-ups that are typically closely-held private companies. Employers and employees are free to negotiate and contract employee stock option arrangements. Nevertheless, in order to be eligible for tax concession treatments, employee stock option arrangements must meet certain requirements set up in the US tax code.

B Taxation of employee stock options in the US

B.1 Statutory Options

There are two types of employee stock options that may be qualified for tax concessions: incentive stock options (section 422 of Internal Revenue Code (referred to as IRC below) ) and options under employee stock purchase plans (section 423 of IRC). These two are referred to as statutory options in the US tax code. Other nonqualified stock options are governed by section 83 of IRC and Treasury Regulations section 1.83-7.

15 Calvin H Johnson, ‘Stock Compensation: The Most Expensive Way to Pay Future Cash’, Spring 1999, 52 SMU

Law Review 423, at 424. Calvin H Johnson also argued in ‘The Legitimacy of Basis from a Corporation’s Own Stock’, (1991) 9 American Journal of Tax Policy 155, that fair market value of stock represents a real cost to the issuer because it is net present value of future, non-deductible cash.

16 Thomas Copeland & J Fred Weston, Financial Theory and Corporate Policy, (3ed, 1992), at 21-22. 17 Joseph Bankman, ‘The Structure of Silicon Valley Start-ups’, (1994) 41 UCLA Law Review 1737, at p1750. 18 Ibid.

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With proper planning, no tax is payable at the time when statutory options are granted or exercised. Statutory options may effectively defer tax payable until the underlying stocks are disposed of19 and thus convert ordinary income to a capital gain20.

B.1.1 Incentive Stock Options

The “incentive stock option” is defined as an option that is granted to an employee for any reason connected with his employment by the employer corporation or its parent or subsidiary, and that must meet the certain criteria21:

The option must be granted pursuant to an employee stock option plan that is approved by the shareholders within 12 months before or after the date such plan is adopted. The approval should comply with the corporate charter and relevant Federal and State law in respect of the shareholder approval required for the issuance of corporate stock or options.22 A study has found that shareholders generally vote to approve stock options but they are sensitive to the share dilution issue.23 Generally speaking, the shareholder approval requirement will not be a problem for a sunrise start-up company because it is usually closely-held and its shareholders have a good understanding of the benefits of adopting employee stock options.

The option must be granted within 10 years from the date such plan is adopted, or the date such plan is approved by the shareholders, whichever is earlier.

The option must not be exercisable after the expiration of 10 years from the date such option is granted.

The option must entitle the employee to purchase the stock in the employer corporation or its parent or subsidiary corporation at a fixed price (referred to as the ‘option price’24 or exercise price) not less than the fair market value of the stock at the time the option is granted.25 Setting a right option price could be problematic to a start-up company because it is hard to determine the fair market value of stock in the start-up company. However, if the company has a good-faith attempt to meet the option price requirement, it is taken to have met the requirement regardless of whether the fair market value of the stock is correctly determined.26 Whether or not there is a good-faith attempt depends on the relevant facts and circumstances.27 This regime offers an incentive for the start-up company to set a low option price and maximise the tax benefits. A good-faith attempt to meet the option price requirement in respect of non-publicly traded stock is demonstrated if the stock is valued by completely independent and well-qualified experts with regard to no lapse restrictions and without regard to lapse restrictions.28

19 Section 421(a) IRC. 20 Sections 1221 and 1222 IRC. 21 Section 422(b) IRC. 22 Reg. Section 1.422-3. 23 Randall S Thomas & Kenneth J Martin, “The Determinants of Shareholder Voting on Stock Option Plans”, (2000)

35 Wake Forest Law Review 31. The article has also identified several key features of the option plans that appear to provoke strong responses from shareholders: option repricing, payments in restricted stock, and the provision of loans to executives for the purchase of shares, etc.

24 See the definition of ‘option price’ in Reg section 1.421-1(e). 25 See also the definition of “option price” in Reg section 1.421-1(e). 26 Reg sec1.422-2(e)(2)(i). 27 Ibid. 28 Reg sec1.422-2(e)(2)(iii) and (iv).

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The option must be non-transferable29 and only exercisable by the employee during his lifetime.

Immediately before the option is granted, the stock owned by the employee must not have more than 10% of the total combined voting power of all classes of stock in the employer corporation, or its parent or subsidiary corporation.30 In determining the 10% voting power limit, stock that the employee may purchase under outstanding options is not included.31 However, stock owned directly or indirectly, by or for the employee’s brothers, sisters, spouse, ancestors, or lineal descendants is treated as owned by the employee, and stock owned, directly or indirectly, by or for a corporation, partnership, estate, or trust, shall be considered as being owned proportionately by or for its shareholders, partners, or beneficiaries. This is referred to as the ‘stock attribution rules’ of section 424(d) IRC. In addition, the 10% voting power limit may be disregarded if the option price is at least 110% of the stock’s fair market value at the time of the grant and the option is exercisable within only 5 years from the date of grant.32

At the time of the grant of the incentive stock options, the aggregate fair market value of the stock that can be purchased subject to the incentive stock options must not exceed $100,000 per employee during any calendar year.33

B.1.2 Employee Stock Purchase Plans

Requirements for an “employee stock purchase plan” are set out in section 423. They include the following criteria:

(a) The plan must be approved by the stockholders of the granting corporation within 12 months before or after the date such plan is adopted. This condition is also found in section 422 that deals with incentive stock options.

(b) Under the plan, options are to be granted only to and to all employees, by reason of their employment, of the employer corporation or of its parents or subsidiary corporation, except some part-time employees34, employees employed less than 2 years, or highly compensated employees35. All employees in a start-up company are employed less than 2 years. Therefore this requirement does not actually impose any restriction on a start-up company. In addition, the requirement is considered to be satisfied even if not all eligible employees participate in an employee stock purchase plan, provided that the plan allows all eligible employees to choose whether to participate.36

29 The option may be transferable by will or the laws of descent and distribution. See sec422(b)(5) IRC. 30 This condition is intended to prevent the conflict of interest as a shareholder and as a management executive. The

limit is imposed on the stock rather than the option. The underlying stock that is subject to the option may possess more than 10% of the total combined voting power.

31 Reg section 1.422-2(f)(2). 32 Reg section 1.422-2(f)(1). 33 To the extent that the aggregate fair market value of the underlying stock exceeds $100,000, such options will be

treated as nonqualified options. 34 They include employees whose customary employment is not more than 20 hours per week, or is for not more than

5 months in any calendar year. 35 The term of “highly compensated employee” is defined in sec414(q), meaning any employee who was a 5% owner

at any time during the year or the preceding year, or who had compensation in excess of $80,000 and was in the top-paid group in the preceding year.

36 Reg section 1.423-2(e)(1).

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(c) No employee can be granted an option if such employee, immediately after the option is granted, owns stock possessing more than 5% of the total combined voting power or value of all classes of stock of the employer corporation, or its parent or subsidiary corporation. In determining the stock ownership, stock that the employee may purchase under outstanding options shall be treated as stock owned by the employee,37 and ‘stock attribution rules’ in section 424(d) also apply. The voting power limitation here is much stricter than its counterpart in incentive stock option provisions because employee stock purchase plan provisions are targeting at broad-based employee stock option plans.

(d) All employees granted such options shall have the same rights and privileges, except that the amount of stock that may be purchased may bear a uniform relationship to the total compensation, or the basic or regular rate of compensation, of employees.

(e) Under the plan, the stock shall be purchased at an option price that is not less than 85% of the fair market value of the stock at the time of grant or at the time of exercise, whichever is lesser. For stock whose price is highly fluctuating, such as stock in a start-up company, it provides flexibility to the start-up company to set the option price by reference to the fair market value of the stock either at the time of grant or at the time of exercise.

(f) The option shall be exercised within 5 years from the date the option is granted, if the option price is to be not less than 85% of the fair market value of the stock at the time of exercise, or otherwise within 27 months from the date the option is granted, (i.e., if the option price is set by reference to the fair market value of the stock at the time of grant and is less than 85% of the fair market value of the stock at the time of exercise).

(g) The employee can not be granted an option which permits his rights to purchase stock under all such plans38 of this employer corporation and its parent and subsidiary corporations to accrue at a rate exceeding $25,000 of fair market value of the stock (determined at the time the option is granted) for each calendar year.39

(h) The option must be non-transferable40 and exercisable only by the employee during his life time. This is the same as under the incentive stock option provisions.

B.1.3 Tax treatment of statutory options

Prima facie, the statutory options granted in lieu of normal wages and salaries may be taxable as property transferred in connection with performance of services under section 83 of IRC. However, section 83 will not apply to a grant of an option where section 421 will apply, or when the option has no readily ascertainable fair market value.41

Section 421 applies to the statutory options if 42:

37 Reg section 1.423-2(d)(1). 38 In determining the $25,000 limitation, nonqualified stock options, incentive stock options and restricted stock

option (sec424(b)) are not taken into account. See Reg sec1.423-2(i)(2). 39 Otherwise, no portion of such option will be treated as having granted under an employee stock purchase plan. See

Reg sec1.423-2((i)(1). 40 The option may be transferable by will or the laws of descent and distribution. 41 Section 83(e)(1) and (3) IRC. 42 Sections 422(a) and 423(a) IRC.

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(a) the employee holds the share acquired under the option for at least 2 years after the granting of the option and for at least one year after the transfer of the share to him; and

(b) at all times during the period beginning on the date of the granting of the option and ending on the day 3 months before the date of the exercise of the option, the option holder was or is the employee of the granting corporation, or its parent or subsidiary corporation.

The non-transferability requirement in sections 422 and 423 and the holding period requirement in section 421 are consistent with the employee-retaining function of employee stock options.

Even if section 421 does not apply, the statutory options will not have a readily ascertainable fair market value because the options are not transferable.43 Hence, in either case, the grant of the incentive stock option or the option under the employee stock purchase plan will not be a taxable event under section 83.

The exercise of the statutory options would not result in any tax if section 421 applies. No income will be recognised at the time of the transfer of the share to the employee upon his exercise of the incentive stock options.44 Moreover, any gain resulting from the increase in the share price will be taxed as a capital gain at a favourable rate on the subsequent disposal of the share. However, there is an exception to the capital gains treatment for the employee stock purchase plan. A part of the gain from the disposal of the stock acquired by exercising the option granted under employee stock purchase plan would be treated as ordinary income, if the option price is less than 100% of the fair market value of the stock at the time of the grant of the option. When the stock is subsequently sold or the employee is dead, the employee’s ordinary income for that income year should include the lesser of:

(a) the excess of the fair market value of the stock at the time of the grant of the option over the option price, or

(b) the excess of the fair market value of the stock at the time of the disposal of the stock or the employee’s death over the option price.45

Correspondingly, the employer cannot deduct any amount under section 162 (as trade or business expenses) with respect to the grant of the statutory options to, or the exercise of the statutory options by, the employee.46 Nevertheless, the deductibility of such expenses does not seem to have any material tax benefit to a start-up company. It takes quite a few years for a start-up company to generate enough profits to offset the option-granting expenses, and meanwhile the start-up company will have already accumulated a substantial amount of start-up losses and expenses.

B.1.4 Benefits of statutory options

Because of the restrictions on the employee stock purchase plan, in particular, the $25,000 limitation and ‘all employees coverage’ requirement, the employee stock purchase plan is not extensively adopted. However, because a start-up company is not restrained by the all employees coverage requirement (as discussed in paragraph 8(2)), an employee shock purchase plan could be used in addition to incentive stock options to compensate its key employees. The limit on the value of statutory options for a key employee will then increase to $125,000 each year. 43 Sections 422(b)(5) and 423(b)(9), and Reg sec1.83-7(b)(2)(i). 44 Section 421(a)(1). 45 Section 423(c). 46 Section 421(a)(2).

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In addition to tax benefits to employees, employer corporations may enjoy an accounting advantage by granting employees statutory options. Expenses with respect to the statutory options usually are not recorded as an expense for accounting purposes although the employer corporation is required to disclose the grant of the statutory option in financial statements.47 Consequently, the employer corporation can reduce its accounting loss (particularly, in a start-up company), or increase its accounting profit. Nevertheless, the United States Financial Accounting Standards Board (FASB) has recently48 announced its final statement on this matter, requiring the option-issuing corporations to estimate the value of the employee stock options and deduct it from financial statements.49 The FASB’s approach on employee stock options has been widely criticised by the technology industry. One reason given by the National Venture Capital Association (NVCA) is that “the stock option expensing mandate will place an undue burden on start-ups and small companies that need to offer employee options to attract talent but have not been given the necessary tools to accurately reflect an expense.”50

The “incentive stock option” provision, section 422 was first enacted in the 1950s and was subsequently repealed in 1976 because of concern as to the doubtful ‘incentive’ effect. However, it was reintroduced in 1981 on the grounds that incentive stock options would “provide an important incentive device for corporations to attract new management and retain the service of executives who might otherwise leave”51. This proposition is consistent with the findings of a recent American study52. Based on the firm’s economic-profit maximisation theory, a firm’s option-granting decision is partly driven by an intention to attract and retain the excellent employee.53

B.1.5 Alternative minimum tax

Although statutory options are tax-advantaged and could defer employees’ tax liabilities, US tax law limits the tax benefits through a general anti-avoidance regime know as the alternative minimum tax. In some cases, the alternative minimum tax may offset all the tax benefits available for statutory options under the regular income tax. In calculating the alternative minimum taxable income, section 421 is disregarded and the gains rising from the exercise of the incentive stock options will be included under section 56(b)(3). The alternative minimum tax system is intended to tax the high income earners who would otherwise have no tax liabilities under the regular income tax regime.54 From 1999 – 2000, the number of individuals subject to the alternative minimum tax has increased

47 B J Hall & K J Murphy, ‘The Trouble with Stock Options’, Summer 2003, 17(3) Journal of Economic Perspectives

49. 48 FASB announced the final statement on 16th of December 2004. 49 Carrie Johnson, ‘FASB Orders Options Counted as Expenses; Lobbyists Look to Head Off Plan’, Financial Section

(E01), The Washington Post, 17 December 2004. 50 ‘FASB Final Stock Option Ruling Lacks Real World Application’, PR Newswire (Washington US), 16 December

2004. 51 Paul R McDaniel, Hugh J Ault, Martin J McMahon & Daniel L Simmons, Federal Income Taxation: Cases and

Materials, New York: Foundation Press, 1998, at 1111. 52 Paul Oyer & Scott Schaefer, ‘Compensating employees below the executive ranks: a comparison of options,

restricted stock, and cash’, Working paper 10221, Cambridge, US: National Bureau of Economic Research, January 2004, http://www.nber.org/papers/w10221.

53 Ibid, at 23-24. The study takes the view that the favourable accounting treatment is not the sole reason underlying firms’ choices of stock options over cash compensation. But it did not conclude that to what extent the option granting is driven by the favourable accounting treatment.

54 Wayne A Simith, Jr, ‘Tax Treatment of Employee Stock Options in High-tech Industry: When the Market Crashes, Make Sure You’re Not On the Corner of Easy Street and Alternative Minimum Tax Boulevard’, 2003, 13 Albany Law Journal of Science and Technology 865, at 878.

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http://www.nber.org/papers/w10221


from 0.132 million to 1.4 million55, largely due to the popular use of the stock options as a form of compensation.56 In a bear market, the taxpayers still would have to pay the alternative minimum tax without benefiting from stock appreciation.

Several bills have been introduced since 2001 to provide relief from the alternative minimum tax with respect to incentive stock options. In August 2001, Senator Joseph Lieberman introduced a bill that would allow [taxpayers] to pay taxes only on the basis of their stock at the point of exercise minus the fair market value of the stock as of April 15, 2001, or on any gains realised a the point of sale if the stock was sold before that date.57 In the same year, the House of Representatives and Senators Charles and John Kerry also introduced similar bills.58 In February 2004, another bill was introduced into the House of Representatives by Republican Jim Gerlach, which would allow a credit against the alternative minimum tax for stocks acquired via incentive stock option that are sold or exchanged at a loss.59 However, none of the bills has given the taxpayers the enough relief that they feel they deserve.60 More recently, calls on repealing Alternative Minimum Tax have been soaring. On 23 September 2004, Democrat Zoe Lofgren introduced H.R. 514161 that would repeal the Alternative Minimum Tax treatment of incentive stock options, changing the taxable event from the exercise of the stock option to the sale of the stock option. Following the American Bar Association Section of Taxation’s Report to the Senate and House Ways and Means Committee on the Alternative Minimum Tax62, Republican Phil English, on 9 March 2005, introduced Alternative Minimum Tax Repeal Act of 2005 into the House of Representatives.63 If the Bill is passed, sections 55-59 of IRC (relating to alternative minimum tax) would be repealed from 1 January 2006 and this tax reform would affect all employee stock options including nonqualified stock options discussed below.

B.2 Non-qualified Stock Options

Non-qualified stock options are those which do not qualify for the concessions discussed in B.1 for “statutory options”.

B.2.1 Application of section 83 at the time of the grant of the option

In the case where section 421 does not apply64, the stock option is treated as nonqualified stock option and is dealt with under section 83.

55 The figure has increased to 3.8 million in 2005, according to US Treasury. See “Fact Sheet: The Toll of Two

Taxes: The Regular Income Tax and the AMT”, Department of the Treasury, 2 March 2005. 56 Above n 54, at 871. 57 S. 1324, 107th US Congress (2001). 58 H.R. 2794, 107th US Congress (2001); S. 1831, 107th US Congress (2001). 59 H.R. 3806, 108th US Congress (2004). 60 Wayne A Simith, Jr, above n54, at 882-885. 61 108th US Congress (2004). 62 2004 TNT 230-18, Tax Analysts, 30 November 2004. The report pointed out that “although the AMT was aimed at

wealthy taxpayers who use exclusions, deductions, and credits to avoid paying their ‘fair share’ of tax, its real burden falls on middle-class taxpayers, … particularly when AMT liability varies based not on total income or deductions but on the types of those items …” and that AMT has caused the hardships to many incentive stock option recipients whose other compensation and assets are relatively modest.

63 H.R. 1186, 109th US Congress (2005). 64 This could be in situations where an option is not qualified to be either an incentive stock option under section

422(b) or an option granted under employee stock purchase plan under section 423(b), or the requirement of the holding period or employment period in section 422(a) or section 423(a) is not satisfied.

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If a stock option granted to an individual in connection with his or her performance of services is not subject to a substantial risk of forfeiture65 and has a readily ascertainable fair market value at the time of the grant of the option, section 83(a) applies and the excess of the fair market value of the stock option over the amount paid for the option is taxed as ordinary income at the time of the grant. The transfer of the underlying stock to the individual upon his or her exercise of the nonqualified stock option will not trigger the application of section 83.66 The option price at which the underlying stock is purchased becomes the basis (cost base) of the stock, and the subsequent sale of stock would result in a capital gain or loss. Correspondingly, the employer can deduct the amount that must be included into the employee’s ordinary income with respect to the stock option at the time of the grant of the option.67

The reference to the market value of the stock option being “readily ascertainable”68 means an option which is (1) actively traded on an established market; or (2) if not actively traded on an established market, all of the following conditions exist: (i) the option is transferable by the optionee; (ii) the option is exercisable immediately in full by the optionee; (iii) the option or the stock subject to the option is not subject to any restriction or condition that has a significant effect on the fair market value of the option; (iv) there is a readily ascertainable fair market value of the option privilege69 (that is an opportunity to benefit during the option’s exercise period, from any increase in the value of the underlying stock without risking any capital), by taking into account the ascertainableness of the value of the underlying stock, the probability of any ascertainable value of the underlying stock increasing or decreasing, and the length of the option’s exercise period. Employer companies can design nonqualified options without readily ascertainable market value by ensuring that any of four conditions above is not satisfied.

It is also arguable that stock in a start-up company does not have a readily ascertainable fair market value because it is not publicly-traded and it has no option privilege. The option privilege in the case of an option to buy is defined to be an opportunity to benefit, without risking any capital, from any increase in the value of property subject to the option during the option’s exercise period. Stock prices of a sunrise start-up company may rise substantially when the business reaches the buy-out or IPO stage. However, on the other hand, because the sunrise start-up business is highly risky and one of its major assets is intellectual property that could depreciate in value rapidly over time, its stock and stock options could be worthless if the business does not succeed. The employees risk capital, ie, the salaries they forgo for the employee stock options, for the potential of substantial increase in stock value. Therefore, an option to buy stock in a sunrise start-up company generally has no readily ascertainable fair market value.

B.2.2 Application of section 83 at the time of the exercise or disposal of the option

If the nonqualified stock option does not have a readily ascertainable fair market value at the time of the grant of the option, the receipt of the option is not subject to tax under section 83.70 However, the transfer of the stock upon the exercise of the nonqualified option, or the disposal of the option would 65 That is, the individual’s right to the option is not conditioned on the future performance of substantial services by

any individual. See section 83(c)(1). 66 Section 83(e)(4). 67 Section 83(h). However, section 162(m) restrains a publicly held corporation from deducting expenses on executive

compensation paid to the CEO or the other 4 highest paid officers to the extent that the amount is in excess of $1,000,000 for the income year. This usually won’t be an issue for a start-up company.

68 Reg sec1.83-7(b). 69 Reg sec1.83-7(b)(3). 70 Section 83(e)(3).

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trigger the application of section 83 and result in ordinary income. The employer is entitled to deduct the amount that must be included into the employee’s ordinary income with respect to the stock option at the time of the exercise or disposal of the option.71 Section 83 applies at the time the option is exercised or otherwise disposed of, even if the fair market value of the option may have become readily ascertainable before the exercise or disposal time.72

In a rising market, it may be wiser for a taxpayer to initially include the value of the nonqualified stock option in ordinary income at the time of the grant by making the election under section 83(b)73 and the subsequent appreciation in value of the option would be taxed as capital gain at a favourable rate. However, section 83(e)(3) prevents the taxpayer from making such election. Section 83 shall not apply to the receipt of the nonqualified stock option without a readily ascertainable fair market value at the time of the transfer of the option. This view has been confirmed in Cramer v Commissioner of Internal Revenue74.

Although nonqualified stock options cannot be used to defer tax payable until the underlying shares are sold, whereas such deferral is possible for statutory options, nonqualified stock options have certain advantages over statutory options:

(a) There is no limit on the value of the nonqualified options granted each year. The limit for statutory options, $100,000 worth of incentive stock options and $25,000 worth of employee stock purchase plan options, may not be enough to attract and retain a highly-skilled employee. Nonqualified options without a readily ascertainable fair market value which are only taxable at the time of exercise would be an attractive supplement to a grant of statutory options.

(b) There is no time limit on the exercisability of the nonqualified options. Nonqualified options are exercisable indefinitely once granted, unlike incentive stock options that must be exercised within 10 years from the grant time or options under an employee stock purchase plan that must be exercised within 5 years. This relief, however, may not be particularly valuable to employees in a start-up company which usually has a life cycle of 10 to 15 years.

(c) Costs of contracting nonqualified stock option arrangements are lower than costs of contracting incentive stock option arrangements or employee stock purchase plans, as nonqualified stock option arrangements involve fewer requirements and hence less compliance work needs to be done.

C Comparison of tax treatment of employee stock options in Australia and in the US

This section compares the Australian and US position.

71 Section 83(h). see also above n 27. 72 Reg sec1.83-7(a). 73 Section 83(b) allows taxpayers to make elections to include in their gross income the excess of the fair market

value of the property transferred over the amount paid for the property at the time of the transfer. Usually, such elections are applicable where the property is not transferable or is subject to a substantial risk of forfeiture, and hence the property is not taxable at the time of transferring the property to the taxpayer.

74 101 TC 225 (1993), pp.245-246.

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Appendix C

C.1 Australian position

In Australia, an employee share option is taxable at the time of grant unless it is a qualifying right to acquire a share in a company75 (hereafter, referred to as “qualifying employee share option”) issued under an employee share scheme subject to Division 13A of Part III ITAA 1936.

As discussed in Chapter 9, taxes on qualifying employee share options can be deferred to the earliest of the time when the options are exercised, when the options are disposed of,76 when employment ceases, or the expiry of 10 years from the grant of options.77 If the shares acquired by exercising the qualifying options are subject to restrictions, taxes may be further deferred to the time when the restrictions end. Alternatively, Division 13A allows the employees to choose the exemption concession for their qualifying employee share options, provided that the exemption conditions in Section 139CE are satisfied.78 The exempted employee share options are limited to AUD1,000 in acquisition discount value at the time of grant.79 The amount of acquisition discount on qualifying employee share options exceeding AUD1,000 in market value is included in the employee’s assessable income in the year of grant. This paper will examine in detail the deferred tax treatment of qualifying employee share options only.

Usually, employee share options are issued by the employer companies to the employees at no consideration. The market value80 of the qualifying options is taxed as ordinary income at the deferred taxable events abovementioned. In the common cases where a qualifying option is exercised by the employee to acquire shares in the employer company, the market value of the option is included in the employee’s ordinary income at the time of the exercise, and then the employee holds the shares acquired under the option as capital assets and hence any subsequent gains realising from the sale of the shares will be taxed as capital gains. This is different from the US tax treatments of incentive stock option and employee stock purchase plans. In the United States, incentive stock options and options under employee purchase plan are not taxable until the underlying shares are disposed of, provided that certain holding period requirements have been met. And the entire gain resulting from the increases in the option value and share value will be taxed as a capital gain.

C.2 Comparison of Australian and US restrictions

Although employee share plans are experiencing increasing popularity in Australia, they have not been commonly adopted by start-up companies.81 The technical requirements specified in Div13A of ITAA 1936 hinder start-up companies from adopting any employee share option plans that qualify for tax concessions. We compare the technical requirements in Australia with those in the US below.

75 The meaning of “qualifying rights” is specified in section 139CD, ITAA 1936. 76 The statutory options in the US are not transferable. Therefore the disposals of employee stock options in the

United States and Australia will not be compared. But the feature of transferability of employee stock options will be discussed below.

77 Section 139CB, ITAA 1936. 78 Sections 139BA and 139E, ITAA 1936. 79 Section 139BA(2), ITAA 1936. 80 If any consideration is paid by the employee to acquire the qualifying options, only the discount amount is taxable.

Generally speaking, the discount amounts are the excesses of the market values of qualifying options at the deferred taxable events abovementioned over the considerations paid by the employees. See section 139CC, ITAA 1936.

81 House of Representatives Standing Committee on Employment, Education and Workplace Relations, Shared Endeavours – Inquiry into Employee Ownership in Australian Enterprises, September 2000, para 2.3.

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First, in Australia, to be a qualifying right, a right/option must be acquired under an employee share scheme. The right must be acquired at a discount to market value by the employee in respect of, or for or in relation directly or indirectly to, any employment of the employee or an associate of the employee.82

Second, in Australia, a qualifying right/option must be granted by the employer company or its holding company to acquire shares in the employer company or its holding company. If the employment relationship terminates, the right/option would cease to be a qualifying right and hence the employee would not be able to defer tax until the right is exercised or the expiry of 10 years from option grant. In the United States, a nonqualified stock option that has a readily ascertainable fair market value will be taxable at the exercise time without any need to satisfy a continuing employment requirement. Gains from an incentive stock option or an option under an employee stock purchase plan will be recognised as capital gains when the underlying shares are disposed, if the continuing employment83 and holding period requirements are met.

Third, in Australia, the shares to be acquired under a qualifying right/option must be ordinary shares. There is no definition of ‘ordinary shares’ in Australian tax law. Nevertheless, the Explanatory Memorandum to the Taxation Laws Amendment Bill (No 5) 198884 states that the ordinary share requirement is to ‘ensure that the shares offered under a scheme are not disadvantaged in respect of voting rights in comparison with similar shares offered by the employer companies’. This requirement is not present in the US counterpart legislation. The US treasury regulation clarifies that in the context of the employee stock options, the underlying stocks could be ordinary stocks or preferred stocks.85 The preferred stock (preference shares) obviously can provide a financial safeguard to the employees of a start-up company whose ordinary shares are highly volatile. The use of the preferred stock also allows the option grant to pass the voting power test discussed below because preferred stocks may not carry any votes.

Fourth, in Australia, immediately after the grant of the rights/options, the employee must not hold a legal or beneficial interest in more than 5% of the shares in the employer company, and not control more than 5% of the votes that could be cast at a general meeting of the employer company. It is not clear-cut whether the 5% limit applies to the shares that can be purchased under the employee share options. Literally, the shares that can be acquired under the employee share options are disregarded in calculating the 5% limit because an option to acquire a share does not constitute a legal or beneficial interest in the shares and does not carry any voting power. Hence, where the employee does not hold more than 5% of shares or votes in the employer company, the grant of employee share options will never violate this requirement. Arguably, once the employee share options pass the 5% shareholding limit test, these options will be qualifying rights forever. Even if the employee exercises some qualifying rights to acquire shares in the employer company and his shareholding exceeds 5% limit, the remaining options do not lose their qualifying status. This feature makes the employee share options more attractive than the employee shares, particularly to key employees or executives of start-up companies who are seeking larger stakes in the companies. Under the United States tax law, neither the shareholding limit nor the restriction on voting power is imposed on nonqualified stock options

82 Section 139C ITAA 1936. 83 There is a 3-month relief period for the continuing employment requirement. As long as the statutory options are

exercised within 3 months from the end of the employment, the option holder is still eligible to defer tax payable on the options to the time when the underlying shares are sold. The employment requirement is relevant to the option holding period only, but not to the share holding period.

84 The Taxation Laws Amendment Bill (No 5) 1988 is regarding section 26AAC that is the ancestor of Div13A. The policy intents in respect of both provisions are considered to be the same. See ATO IDs 2003/1067 and 2003/1068.

85 Reg sec1.421-1(d).

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Appendix C

which may be eligible for the deferred tax treatment at the time of exercise if they do not have readily ascertainable fair market value. The use of incentive stock options is subject to the restriction of 10% combined voting power. Nevertheless, the percentage of stock ownership is determined immediately before the grant of the options,86 and the stock that can be purchased under the outstanding options by the employee will not be taken into account.87 Furthermore, this restriction can be circumvented by using preferred stocks that do not carry any voting rights.

C.3 Additional US restrictions

On the other hand, the US employee stock options provisions set out other conditions that are not prescribed under Australian employee share scheme regime.

First, in the United States, a statutory option must be granted under an employee stock option that is approved by the shareholders within 12 months before or after the date such plan is adopted. However, this requirement has been criticised as being ‘unnecessary and unwise’ because (1) the complexity of compensation schemes and the cost of understanding them are beyond the ability of the average shareholder; (2) ordinary business decisions should be made by the company’s management, not shareholders; and (3) a shareholder with a diverse portfolio will have many corporate compensation packages that require monitoring and voting.88 Australian tax law does not have such requirement.

Second, in the United States statutory options are not transferable and are exercisable only by the employee to whom the options are granted during his or her life time. In Australia, qualifying rights under an employee share scheme are transferable, and tax payable in respect of the qualifying rights/options can be deferred to the time of disposal or exercise. Prima facie, Australian tax law gives the employee more flexibility to benefit from the use of employee stock options as remuneration. However, the favourable tax treatment on employee stock options is justified on the ground that they provide incentives to attract, retain and motivate talent employees. Allowing employees to transfer such options to outsiders would mitigate the incentive impact expected from the use of the employee stock options and is not consistent with the legislative aim. Nevertheless, a transferable nonqualified stock option under the US tax law could be taxed at same time as those under Australian tax law, ie at the time of exercise, if the argument, discussed above, that there is no readily ascertainable fair market value of the option privilege in a start-up company is successful.89

Third, in the United States, the total amounts of fair market value of stock (at the time of grant) that can be purchased in one calendar year, subject to incentive stock options and options under an employee stock purchase plan must not exceed $100,000 and $25,000 respectively under the US tax law. This limitation may be useful in preventing the abuse of employee stock option in terms of tax avoidance although the proper figure of the limitation may be controversial. However, there is no such cap on the qualifying rights in each calendar year under the Australian tax law, if the deferred concession applies.90

Fourth, the US tax law requires that an employee stock purchase plan must cover every employee in the employer company. Nevertheless, because of the definition of ‘employee’, the start-up companies

86 Reg section 1.422-2(f)(1). 87 Reg section 1.422-2(f)(2). 88 Roshan Sonthalia, ‘Shareholder Voting on All Stock Option Plans: An Unnecessary and Unwise Proposition’, April

2004, 51 UCLA Law Review 1203. 89 Reg section 1.83-7(b)(3). 90 If the employee chooses the exemption concession, AUD 1,000 limit applies. See para 25 above.

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do not expose to this restriction.91 Incentive stock options are not subject to any employee coverage requirement. In Australia, qualifying employee share options are free from the employee coverage requirement.92 However, where the employer company grants employee shares, at least 75% of the permanent employees in the company must be or have been entitled to acquire shares or rights in the company.93 The start-up companies are unable to meet this criterion due to the definition of ‘permanent employees’94 although this criterion may be waived under the Tax Commissioner’s discretion.95 In this regard, employee share options are easier choices to Australian start-up companies.

D Conclusion

Tax policy should encourage employee stock option compensation in start-up companies. In Australia, due to the ‘permanent employees’ requirement, it is almost impossible for start-up companies to adopt employee share plans that are qualified for concessional treatments. Start-up firms that seek to reward employees equity-based compensations with tax concession treatments can only use employee share option plans that meet certain criteria. Gains from qualifying employee share options are taxed as ordinary income at a deferred time, i.e., when the options are exercised. The United States has a more friendly tax environment for employee stock options. The US tax law encourages employees to retain ownership in companies’ stock options and stock in return for deferral of tax liability, and ‘capital gains’ tax treatment rather than ‘ordinary income’ tax treatment. Tax liability can be deferred to the time when the underlying shares are disposal of, rather than the time when the options are exercised or disposed of. Favourable tax treatment on employee stock options under the US tax law can be more easily obtained by start-up companies than those under the Australian tax law. Furthermore, without being restrained by many of those requirements, nonqualified stock options under US tax law may be taxable at the time of exercise.

Australian employee share scheme provisions seem to be more like an anti-avoidance rule designed to limit use of employee shares and options rather than an incentive regime encouraging the use of employee share options and maximising the benefits of adopting employee share options. The Australian government has been considering proposals to reform employee share scheme regime since

91 See Para 8(2) above. 92 Sections 139CD(1)(b) and (5), ITAA 1936. 93 Section 139CD(5), ITAA 1936. 94 ‘Permanent employees’ is defined as full-time or permanent part-time employees with at least 36 months service.

See section 139GB, ITAA 1936. 95 Ann O’Connell, “Providing shares or rights as remuneration to an intellectual property provider” at para 1.5. See

also section 139CD(5), ITAA 1936.

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Appendix C

200096. However, little has been done since then. Start-up intellectual property firms are particularly seeking favourable changes in the tax treatment of employee share options.97 A separate regime for employee share option schemes in start-up intellectual property firms should be urgently considered by the Australian government. The US incentive stock option model provides useful guidance.

96 House of Representatives, Standing Committee on Employment, Education and Workplace Relations, Share

Endeavours – Inquiry into employee share ownership in Australian enterprises, September 2000. 97 Rob O’Neill, “Ideas for the Clever Country”, The Age, September 28, 2004.

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