Originally, sale and leaseback transactions were applied to tangible assets, such as plant, machinery and equipment. However, since the mid‐1990's, its application has increasingly been extended to incorporeal property, including trademarks, patents, designs, copyright and know‐how. When applied to intellectual property (IP), the "leaseback" and associated "rental payments" are more correctly referred to as "licence" and "royalties", respectively.
On the face of it, intellectual property has the attributes that render it suitable for use in sale and leaseback transactions: intellectual property is an incorporeal/intangible ‐ having no physical presence that may be required in the operations of the seller’s business; it typically has a high value ‐ generally ranging between 25% and 80% of a company's total asset value; and it is easily transferable ‐ generally, transfer requires the conclusion of a written assignment, the recordal of the assignment on the relevant intellectual property register(s), together with delivery of the registration certificates.
A typical sale and leaseback transaction comprises:
The benefits generated by the transaction include:
Depending on the benefits sought, the transaction may have to be "tweaked" to circumvent the anti‐avoidance provisions of s23D and s23G of our Income Tax Act. However, such actions are seldom divorced from additional tax risk.
You will appreciate that a sale and leaseback is akin to a loan ‐ X receives R(capital) upfront and repays this together with (discounted) interest (in the form of minimum royalties) over the life of the loan (the initial period of the licence). But, whereas only the interest on a loan is deductible, a sale and leaseback "rolls" the interest up with the capital and results in X claiming deductions in respect of both, while the bank accrues the same income as it would have in terms of a loan (R(interest)).
Other "tax loops" could be added to a standard sale and leaseback transaction to increase its aggression and "tax efficiency". For example, if:
significant (albeit not necessarily legitimate) additional tax benefits would result.
However, the mere fact that a sale and leaseback transaction looks like a loan is not sufficient to undermine its legitimacy from a tax perspective. This is clear from the following statement in Commissioner for Inland Revenue v Conhage (Pty) Ltd 1999 (61) SATC 391 (SCA) at p395:
"In the present case Tycon required capital to expand its business. Firstcorp was prepared to make the funds available. Both parties were aware of the tax benefits to be gained from sales and leasebacks and decided to follow that course."
Due to the complexity of this type of transaction, to conclude an intellectual property sale and leaseback transaction requires expertise in the fields of tax, the law of contracts (in particular sale and licensing), intellectual property valuation and intellectual property law. Without the requisite expertise in any one of these fields, the parties may easily succumb to the pitfalls and hurdles placed in their way by our law. Our case law is particularly troublesome in that not only do various judgments contradict each other but the immature state of our law in this area encourages our Courts to look upon foreign law for inspiration in completing our legal canvass.
Accordingly, in the land of tax structures, intellectual property sale and leaseback transactions are the preserve of the risk‐tolerant/immune. As long as a colourable commercial rationale is devised, the parties may well pass the line of defence drawn by our General Anti‐Avoidance Rules (GAAR) (previously s103(1)), unhindered. However, a "transaction of appeasement" that artificially incorporates the specific interests and preferences of the seller (X), purchaser (Y) and advisor could well find a tough opponent in the doctrine of substance over form, which resorts to inter alia the following factors in a drive to remove the cloak of artificiality from the transaction and reveal the underlying loan:
Defeat at the hands of the doctrine of substance over form may taint the transaction with the brush of fraus legis, with the consequences that: the seller (X) is exposed to both interest and additional tax in terms of s89quat (interest) and s76 (200% penalty) of the Income Tax Act; and the advisor falls vulnerable to the criminal sanction of fraud and reporting actions in terms of s105A of the Income Tax Act. In such instances, the parties also have no ally in time, as disguised transactions are immunised against the normal 3‐year prescription period in terms of s79 of the Income Tax Act.
Finally, despite the decision regarding the nature of royalties in the BP case (SCA), the principle relied upon in the court a quo (ITC11454) that royalty payments made to maintain and retain goodwill, market share, name, customers and reputation should properly be regarded as expenditure of a capital nature, could be relied upon by SARS ‐ in my opinion, sale and leaseback transactions are most probably the only transactions that could trigger the application of this principle. If successful, the royalty payments by X would be regarded as capital in nature and therefore not deductible for tax. This result would render this transaction less attractive than a vanilla loan.
Accordingly, despite early success by the taxpayer in Conhage, which may have compelled Neville Chamberlain to wave the judgment and proclaim "peace in our time", the questions still remain:
(a) intellectual property sale and leaseback transactions ‐ tax avoidance or tax evasion?
(b) intellectual property sale and leaseback transactions ‐ do they actually work?
Only time will tell … or does it depend on the facts?
Articles: Structured finance