Prior to January 2004, allowances for the acquisition of intellectual property (IP) was regulated by s11(gA). According to that section:
11(gA).- Expenditure actually incurred by the taxpayer in-
(iii) acquiring by assignment any patent, design, trademark, copyright or other property of a similar nature or any knowledge connected with the use of such patent, design, trademark, copyright or other property or the right to have such knowledge imparted.
If such patent, design, trademark, copyright, or other property or knowledge is used by the taxpayer in the production of his income or income is derived by him therefrom…
(Note: trademarks were specifically excluded from this section with effect from 29 October 1999)
Meaning of “other property of a similar nature”
This phrase was interpreted in the case of CSARS v SA Silicone Products (Pty) Ltd 66 SATC 131 (SCA) as follows:
[property of a similar nature must] embrace their intellectual origins, i.e.:
- their derivation from a creative mind
- their potential for commercial exploitation
- the fact that the law regards such exploitation as creating a justifiable monopoly which is available only to the creator of the property or persons to whom the creator transfers his rights according to law; and
- that the law accords the rights and protection of ownership to such property.
Furthermore, Goldblatt J in ITC 1783 required any asset falling within the ambit of s11(gA) to confer a “protectable right”.
Meaning of “used in the production of income”
S11(gA) requires the IP to be used in the production of income or income to be derived therefrom.
SARS’ interpretation of this phrase is that “use” requires the performance of an infringing act. Infringing acts generally include:
- make, use, import, dispose of, or offer to dispose of a protected article or exercise a protected method
- use within a registered class of an identical or similar mark such that it is likely to cause deception or confusion
- make an adaptation or reproduction of the copyrighted work
Example: Use of recipes to make loaves of bread
The purchaser argues (and we will assume) that recipes are protected by copyright. According to SARS’ interpretation, copyright is only “used” when the purchaser makes a reproduction or adaptation of the document on which the recipe is printed. The making of a loaf of bread from the recipe is too far removed to be considered either a reproduction or an adaptation of the document. Since, the purchaser produces income from making and selling loaves of bread (as compared to making reproductions of the document), SARS will reject the purchaser’s s11(gA) allowance on the basis that the copyright is not “used in the production of income”.
Similarly, it is arguable that copyright subsisting in software is not “used in the production of income”.
As from 1 January 2004, allowances for the acquisition of IP have been regulated by s11(gC)
This section is very similar to s11(gA)(iii), except that the phrase “used in the production of income” was originally replaced by the phrase “is brought into use for the first time by the taxpayer for the purposes of his trade”. On the face of it, this did not necessarily require “use” to be linked to the production of income. Therefore, it was arguable that deductions could be claimed in terms of s11(gC) in similar circumstances where such deductions would previously have been denied under s11(gA). However amendments to s11(gC) in 2007 combined the two phrases together and s11(gC) now reads “… which shall be allowed during the year of assessment in which that invention, patent, design, copyright, other property or knowledge is brought into use for the first time by the taxpayer for the purposes of the taxpayer’s trade, if that invention, patent, design, copyright, other property or knowledge, as the case may be, is used by the taxpayer in the production of his or her income.”
Please note that, despite the introduction of s11(gC), allowances in respect of IP acquired prior to 1 January 2004 should continue to be claimed under s11(gA).
Discussion on specific assets
a. Common law trademarks
Common law (i.e. unregistered) trademarks constitute “other property of a similar nature”. However, due to its nature, common law trademarks may not be assigned without the sale of the related business as a going concern.
As from 29 October 1999, no allowances for either registered or common law trademarks may be claimed in terms of either s11(gA)(iii) or s11(gC).
With the exclusion of trademarks from s11(gA)(iii) in October 1999, the focus shifted to transactions using software/copyright. The problem with these transactions is that the software/copyright is nearly always valued using the “relief from royalty methodology”, which is inappropriate and generally results in the software/copyright being grossly overvalued (often by more than a factor of 10).
c. Unregistered designs
Both s11(gA)(iii) and s11(gC) apply to “Designs as defined in the Designs Act, 1993 (Act No. 195 of 1993)”. According to the Designs Act, a “design” is defined as either an aesthetic design or a functional design. In turn: an aesthetic design is defined as “any design applied to any article, whether for the pattern or the shape or the configuration or the ornamentation thereof, or for any two or more of those purposes, and by whatever means it is applied, having features which appeal to and are judged solely by the eye, irrespective of the aesthetic quality thereof”; and a functional design is defined as “any design applied to any article, whether for the pattern or the shape or the configuration thereof, or for any two or more of those purposes, and by whatever means it is applied, having features which are necessitated by the function which the article to which the design is applied, is to perform, and includes an integrated circuit topography, a mask work and a series of mask works”.
Surprisingly, these definitions have been interpreted by some practitioners to require the existence of neither a design application nor a design registration. Relying on this interpretation, these practitioners have “valued” (using the relief from royalty methodology and “the 25% rule”) all designs, even designs not protected by the Designs Act and encouraged their clients to claim allowances in terms of either s11(gA)(iii) or s11(gC). Apart from being patently absurd, such an interpretation conflicts with the principles laid down in ITC 1783 and CSARS v SA Silicone Products (Pty) Ltd 66 SATC 131, which require the s11(gA)/s11(gC) assets to confer a “protectable right”.
It has also been argued that unregistered designs are protected by the law of unlawful competition (refer to the case of Schultz v Butt 1986 (3) SA 667 (A)), and that they consequently fall within the category “other property of a similar nature”. However, this ignores the fact that the law of unlawful competition (unlike passing off) merely proscribes certain conduct that our courts regard as unlawful, and does not act to protect the asset. In the absence of a “protectable right”, such property cannot fall within the ambit of either s11(gA)(iii) or s11(gC). On the other hand, if the taxpayer could prove that an unregistered design (not being a functional design) was protected by the law of passing off, such design could arguably fall within the scope of these allowance sections. But this is a high hurdle to overcome.
d. Client lists
Since October 1999, exorbitant values have been ascribed to “client lists”. On their own, client lists do not fall within the ambit of s11(gA). In an artificial attempt to remedy this, such know-how has in certain instances been assigned together with the copyright subsisting in the related work. However, it is doubtful whether such copyright itself fulfils the requirements of either s11(gA)(iii).
It should also be borne in mind that internationally there is a trend to specifically exclude client lists from IP allowance sections – e.g. the new IFRS adopted in Australia in January 2005, new std 138 of AU accounting standards Board excludes customer lists from the definition of IP.
Licences seldom confer a “protectable right” or the “rights and protection of ownership” upon the licensee. As such, licences will typically fall outside the ambit of s11(gA)(iii) / s11(gC). Upfront payment of a license fee is generally deductible in terms of s11(f).
In addition, it may also be argued that a licence is not acquired by assignment. In “patent-speak”: the underlying intellectual property asset is acquired by assignment, whereas, rights in terms of a licence may only be transferred by way of a cession of rights and delegation of obligations (also see Video Parktown North and ITC 1726).
e. Domain names
An owner of a domain registration has a contractual right in respect of that domain only. Not only are these rights not recognised as intellectual property, but the principles laid down in ITC 1783 and CSARS v SA Silicone Products (Pty) Ltd would also apply to exclude this type of asset from the ambit of both s11(gA)(iii) and s11(gC).
Let’s be honest, historically, s11(gA)(iii) and s11(gC) allowances were abused. During the 1990s, many businesses were overvalued and purchased by way of a sale of assets (paid for by the issuance of shares) and the inflated value of the goodwill was artificially attributed to the intellectual property. To add insult to injury, much of this intellectual property was then “written-off” over a relatively short period of time (often between two and three years).
However, the exclusion of trademarks from the allowance sections on 29 October 1999 and increased vigilance by SARS has done much to stem this abuse.
The anti-avoidance provisions in s11(gA)(dd) and s11(gC)(bb) (Now s23J) limits the allowances that may be claimed consequent to the assignment of IP between “connected persons” (as defined) to the lesser of the market value of the IP and the cost to the assignor of such IP. Some argue that the section may be circumvented by:
A assigning IP (cost: Rx) to B (a connected person in respect of A) for Ry and B assigning the IP (cost: Ry) on to C (a connected person in respect of both A and B) for Ry.
Presuming that the market value of the IP is Ry, C’s allowance is limited to the lesser of the cost to C (i.e. Ry) or its market value (i.e. Ry) – Voila! the section has effectively been circumvented. … Not so:
The contra-fiscum principle does not apply to anti-avoidance provisions. On the contrary, the Appellate Division in Glen Anil Development Corp held that such sections must be read robustly so as to give effect to its purpose and suppress the mischief against which section is directed. Accordingly, there is a strong argument in favour of viewing the transaction as a composite transaction in terms of which A is always regarded as the assignor.
Alternatively, SARS could have regard to the true substance of the above composite transaction, as discussed by Lord Bridge in the UK case of Furniss v Dawson at p158:
“When one moves, however, from a single transaction to a series of inter-dependent transactions designed to produce a given result, it is, in my opinion, perfectly legitimate to draw a distinction between the substance and the form of the composite transaction without in any way suggesting that any of the single transactions which make up the whole are other than genuine. This has been the approach of the United States Federal Courts enabling them to develop a doctrine whereby the tax consequences of the composite transaction are dependent on its substance, not its form. I shall not attempt to review the American authorities, nor do I propose a wholesale importation of the American doctrine in all its ramifications into English law. But I do suggest that the distinction between form and substance is one which can usefully be drawn in determining the tax consequences of composite transactions and one which will help to free the Courts from the shackles which have so long been thought to be imposed on them by the Westmister case.”
The principles in Furniss were subsequently summarised by Lord Oliver in Baylis v Gregory at 507 as follows:
“As the law currently stands, the essentials emerging from Dawson appear to me to be four in number: (1) that the series of transactions was, at the time when the intermediate transaction was entered into, pre-ordained in order to produce a given result; (2) that the transaction had no other purpose than tax mitigation; (3) that there was at that time no practical likelihood that the pre-planned events would not take place in the order ordained, so that the intermediate transaction was not even contemplated practically as having an independent life; and (4) that the pre-ordained events did in fact take place. In these circumstances the court can be justified in linking the beginning with the end so as to make a single composite whole to which the fiscal results of the single composite whole are to be applied …
There is a real and not merely a metaphysical distinction between something that is done as a preparatory step towards a possible but uncertain contemplated future action and something which is done as an integral and interdependent part of a transaction already agreed and, effectively, pre-destined to take place. In the latter case, to link the end to the beginning involves no more than recognising the reality of what is effectively a single operation ab initio. In the former it involves quite a different process, viz that of imputing to the parties, ex post facto, an obligation (either contractual or quasi contractual) which did not exist at the material time but which is to be attributed from the occurrence or juxtaposition of events which subsequently took place. That cannot be extracted from Dawson as it stands not can it be justified by any rational extension of the Ramsay approach.”
In addition, s23J requires elements of composite transactions to be spaced by a considerable period of time.