Tax nature of royalty payments

Is the case of BP Southern Africa (Pty) Ltd v CSARS (SCA) the last word on the nature of royalty payments? In my opinion, it is not. The judgment merely applies long‐standing principles of capital / revenue expenditure to the facts of that case, which facts were previously misconstrued by the lower Tax Court.

The debate should be of interest to all South African taxpayers that make royalty payments to foreign entities. If the nature of the payments is regarded as revenue, they may be deducted for tax purposes. However, where they are classified as capital in nature, corresponding tax deductions are typically disallowed.

The BP case is the most recent case in a long line of cases and to focus on it alone would do little to clarify the nature of royalty payments.

The debate began with the case of CSARS v Kajadas Cosmetics (Pty) Ltd. The facts of that case were: Kajadas and SA Matis (a French company) concluded an Exclusive Distribution Licence in respect of beauty products. In terms of the agreement, Kajadas undertook to purchase the beauty products from Matis and enjoyed the exclusive right to sell them in South Africa in consideration for the payment of an annual royalty in the amount of US$100,000. In his judgment, Roux J held:

"The respondent acquired the right to be the exclusive vendor of Matis' products in a vast area. For this the respondent had to pay. Matis could quite simply have distributed its products via many outlets and dealers. To acquire the exclusive rights was to create the income earning machine (Secretary for Inland Revenue v Cadac Engineering Works (Pty) Ltd 1986 (2) SA 511 (AD)). It represents a capital asset."

In my respectful opinion, Roux J came to the right conclusion, but for the wrong reasons. Instead of focusing on the exclusivity of the licence, the Court should have applied the doctrine of exhaustion of rights, which means that once articles protected by intellectual property rights are sold by or with the consent of the intellectual property owner or his licensee, the articles may later be dealt with by the purchaser as though they were not covered by the intellectual property rights (see Stauffer Chemical Co v Agricura Ltd). Accordingly, since Kajadas purchased the beauty products from Matis, the doctrine of exhaustion of rights applied to permit Kajadas to import and sell the products in South Africa absent of a licence. In other words, Kajadas did not require a licence in order to conduct its trade. The licence was merely concluded in order to empower Kajadas to prevent the importation and sale of Matis products within South Africa by third parties. Since the royalty payments were made in order to secure a monopoly, such expenditure is capital in nature.

As such, royalties paid in terms of most exclusive distribution licences are capital in nature.

But, this is not to say that exclusivity plays no part in determining the nature of royalty payments. In order to conduct trade, a licensee may require a non‐exclusive licence. The "exclusivity premium" paid to convert such licence into an exclusive licence is paid solely to secure a monopoly. Various surveys have been conducted to determine the average exclusivity premiums paid in terms of exclusive licences, and the results range from 20% to 300%. It is therefore open to SARS to apportion royalty payments between a deductible "royalty payment" and a non‐deductible "exclusivity premium". Conservatively, SARS could default to an 80:20 apportionment rule.

A further principle was distilled in the tax case ITC 1726. The facts of that case were: the appellant tendered for, and was granted a licence to construct, operate and maintain a nationwide cellular radio telephony service on a non‐exclusive basis. In terms of the licence, the licensee paid an initial basic cellular licence fee of R100 million prior to commencing commercial operations. The duration of the licence was 15 years, with renewal provisions. In his judgment, Joffe J held that

"the right conferred by the licence is not a right to use but a right to conduct the specific undertaking, i.e. a telecommunication service: it is clear that the payment has been made for the right to construct, operate and maintain a cellular radio telephone service. Accordingly, the licence has not been routinely incurred in the running of the appellant's business but constitutes expenditure that has been incurred to found and lawfully commence the operation of appellant's income‐earning structure, i.e. the expenditure is of a capital nature."

Accordingly, in my opinion where the licence is a legal prerequisite for trade imposed by the State, the corresponding royalty payments are capital in nature. This principle should apply to all liquor, broadcasting, gambling, fishing and similar licences.

However, one must be careful not to confuse a legally imposed prerequisite to trade with a voluntarily imposed prerequisite to trade. For example, no legal prerequisite prevents a person from manufacture jeans. Where a person voluntarily elects to conclude a trademark licence with Levi's to brand his jeans "Levi's", such a license does not constitute a legal prerequisite to trade and the principle in ITC1726 consequently finds no application.

Turning now to the BP case, the tax court in Case no. 11454 (ITC1798) initially found in favour of SARS on the principal ground that BP SA made payments to BP Plc in terms of a trademark licence in order to maintain and retain its goodwill, market share, name, customers and reputation. What Waglay J overlooked was that since BP SA never owned the trademarks in the first place, BP SA had nothing to maintain and retain. As such, the facts of the case did not fit within the principle and the principle did not apply. In my opinion, this case should have been brought on the grounds of economic ownership of the trademarks and transfer pricing (recognising that South Africa’s fuel industry is a regulated market).

However, the reversal on appeal did not necessarily erase the principle that royalty payments in terms of a trademark licence to maintain and retain (as compared to obtain) goodwill, market share, name, customers and reputation are capital in nature. As such, this principle espoused by the Tax Court may still find application in trademark sale and leaseback transactions.

There has also been some discussion regarding the nature of "royalties" in franchise agreements. In this regard, one should recognise that franchise agreements are composite agreements comprising a supply agreement, provision of services agreement, and licence agreement. In practice, the "royalty" payments should be apportioned between these constituent parts and each portion analysed individually.

Finally, one must also be careful when analysing the nature of upfront license fees. Despite the case of ITC1822, licence fees are frequently capital in nature and therefore only deductible in terms of s11(f) of our Income tax Act.

(Updated 2007)

Articles: Taxation