S23I licensing arbitrage


When South African IP is assigned offshore, few negative SA tax consequences follow: capital gains tax triggered by the disposal is at least 50% of the income tax rate and IP CGT base costs minimise this exposure. But, once transferred, potential future SA tax benefits thrive: royalty payments are tax deductible in the SA licensee and subject to tax at a reduced rate in the foreign licensor’s hands ‐ a flow of royalties (often circular) that generates a significant tax arbitrage that could reduce the SA licensee's effective SA tax rate by up to 40% in perpetuity.

Concerned about the potential tax losses, Treasury introduced s23I into our Tax Act, effective 1 January 2009. According to this section, where Tainted IP is licensed to residents, the licensees may only claim tax deductions for payment of royalties to the extent that the royalty receipts by the licensor do not “constitute income”. In other words, where the royalty receipts by the licensor are exempt from tax in South Africa, the licensee will be denied related tax deductions.

If a review of foreign patents is anything to go by, more than 400 patent licences may be denied royalty deductions. But, the largest impact is expected to be felt in the area of trademarks, where free lunches evolved into veritable feasts, with excessive royalties being paid over many years in respect of many trademarks ‐ whereas royalties payable in respect of patents and designs are limited to specific product ranges and to the remaining life of the patent (20 years) / design (10 or 15 years), trademark royalties can be levied on the entire product and service range of a company for as long as the business continues to operate.

Tailored anti‐avoidance mechanisms have also been introduced to prevent licensees circumventing the section by merely interposing third parties that convert royalty streams into derivative payments, such as credit default swaps, that generate SA deductions that match the SA royalty income. This is a sign that our legislature is waking up to the use of derivatives to re‐characterise and divert income streams to low tax jurisdictions.

For example: OpCo has a trademark. Trader buys it for R100m and licences it back to OpCo for royalties totalling R200m over 8 years (assuming present value of R100m). Trader then sells the bare dominium (i.e. ownership rights less rights of use) in the trademark to a subsidiary of OpCo and sells the royalty promissory notes to a bank for R100m (i.e. the present value). The bank in turn removes this R100m "loan" from its books by selling a credit default swap (CDS) to its Mauritian cell captive. The terms of the CDS are as follows: MauritianCC pays R100m upfront and receives the royalties (totalling R200m) as they are payable. Both the Trader and the Bank are in a tax neutral position, OpCo claims R200m as royalty deductions in terms of the Act and the MauritianCC never pays SA tax. There is a R200m synthetic arbitrage on the royalty payments and the royalties may be returned as tax exempt foreign dividends to the bank without triggering our controlled foreign company (CFC) tax provisions.

Furthermore, the section has the effect of generally denying deductions to "traders" of IP ‐ traders will in future not be entitled to claim deductions for the acquisition of "IP trading stock" where the corresponding receipt in the hands of the seller is capital in nature. This should impact the manner in which existing IP sale and leaseback transactions are structured.

(Updated 2007)

Articles: Taxation