A Technical Note By The Inland Revenue
| Summary | ||
| Introduction | ||
| Shape of reform | ||
| Particular aspects | ||
| Transition | ||
| Income from intangible assets | ||
| Deduction at source | ||
| Annex: International comparisons | ||
| How to Comment | ||
S.1 The economy is increasingly knowledge driven. Knowledge is important to all industries, "low tech" and "high tech", because it is crucial to innovation and the ability to create and exploit new products and markets. Intangible assets are an important resource in the knowledge based economy, so it is important that the tax system treats them in an up to date way. Modernisation in this area will help to meet the Government's aims of ensuring that the UK is an attractive place in which to do business, and that UK businesses can compete successfully.
S.2 So, to promote modernisation and innovation, the Government is considering a reform of the taxation of intellectual property, goodwill and other intangibles. This would:
S.3 The Government wishes to look at possibilities for reform in consultation with business. The aim at this stage is to canvas views as widely as possible in order to ensure that what emerges from this process is workable, well thought-out, and meets the Governments objectives for the tax system and its wider economic aims.
S.4 The emphasis of the Technical Note is on the corporate sector where the need for reform is most pressing. The main focus of the reform will be on promoting simplicity, increasing flexibility, and minimising compliance costs, while better equipping the tax system to meet the needs of today's economy.
S.5 The Note looks at the scope for aligning tax and accountancy treatment as closely as possible as a way of achieving these objectives. This would also eliminate the capital-revenue divide in this area of the tax system. So everything would be taxed and relieved under an income regime.
S.6 Getting closer to the accounts means that some businesses may be tempted to write down intangible assets faster to accelerate their tax relief. The Technical Note considers how this issue might be addressed. It initiates a debate on whether it will be possible to adopt businesses' own write-off rates, or whether a scheme with a set rate of amortisation for all intangibles would be a practicable way forward.
S.7 The Technical Note also looks at some issues raised by the treatment of income from intangible assets. These include the spreading rules which apply to certain income from intellectual property (an income tax not a corporation tax matter) and whether deductions for expenses should be allowed against royalty income earned by non-residents.
S.8 There are also proposals for modernising the rules governing the deduction at source from royalty payments. These are aimed at aligning the scope of the requirement to make deductions with international standards, and improving the procedures for giving relief due under treaties.
S.9 The Government is interested in hearing views on the issues raised in this Note. The current intention is to publish draft legislation at the time of the Pre-Budget Report and invite comments before incorporating it in the 2001 Finance Bill.
1.1 In the March 2000 Budget the Government announced that it was 'extending the scope of the review of the taxation of intellectual property to include the possibility of tax relief for the costs of purchasing goodwill and some other intangibles. This reflects the increasing importance that intangible assets have to business'. This Technical Note looks at key issues for reform.
The overall picture
1.2 The world economy is changing rapidly. Developments in technology and communications are opening up new markets and increasing international competition. The Government's aim is that in the new global market place: · the UK should be an attractive environment in which to do business; and · UK businesses can compete effectively.
1.3 Budget 2000 proposed a wide-ranging package of tax measures to help UK enterprises meet the new challenges. Some of these measures (for example changes to the group relief rules and capital gains rules for groups) are designed to give businesses more flexibility over how they choose to structure and operate. The current Technical Note, along with the parallel Technical Note Corporation tax: chargeable gains deferral relief for substantial shareholdings, take this process further.
Intangible assets
1.4 The economy is increasingly "knowledge" driven. Knowledge is important to all industries, whether "high tech" or "low tech" because it is crucial to innovation, and the creation and exploitation of new products and markets. Intangible assets are a key element of the knowledge economy and an important source of competitive advantage for businesses. How companies manage and develop their intangible assets has become a crucial factor in determining their competitiveness in national and global markets.
1.5 Against this background, it is important that the tax system deals with intangible assets in a modern and effective way. This is not presently the case. Our current rules governing the tax treatment of intangible assets are complex, inconsistent and out of date. For example, different classes of expenditure are written off for tax at different rates, or not at all, with no overarching rationale. This causes competitive disadvantage to UK businesses in the global market place and may lead multinational companies to acquire and own their intangible assets and goodwill outside the UK.
1.6 These issues have been tackled in a number of our competitor countries. Over the last decade, other countries such as the US have reformed their tax systems in response to the growing importance of intangibles. Approaches adopted elsewhere are considered briefly in an annex.
1.7 So, if the UK is to compete, our tax system needs to be brought up to date too. Modernising the regime would further the Government's aim of ensuring that the UK is an attractive place to do business, and that British businesses can compete effectively in the global market place.
Promoting innovation
1.8 The Government initiated a wide-ranging debate on innovation with the March 1998 consultation document 'Innovating for the future'. Since then a range of measures have been introduced by the Chancellor, the Secretary of State for Trade and Industry and other Ministers to promote innovation and competitiveness.
1.9 Specifically in the field of taxation, the measures taken include the research & development tax credit for small and medium sized companies, tax incentives to promote corporate venturing, and enterprise management incentives. All these reforms should benefit innovative, growing firms. In Budget 2000, the Chancellor also announced the abolition of stamp duty on intellectual property transactions, and a new tax relief for the cost of acquiring spectrum licences and indefeasible rights of use (IRUs) in telecommunications cables.
The shape and scope of reform
1.10 The emphasis of this Technical Note is on the corporate sector where the need for reform is pressing. The possible ways forward discussed in Chapters 2 and 3 focus on bringing tax and accounting treatment closer together across the full range of intangible assets (including goodwill). In accounting terms, these are the assets which come within the scope of Financial Reporting Standard 10 (FRS10).
1.11 There are some important considerations suggesting that a reform on this basis should apply to corporation tax only. Firstly, any reform which included goodwill in an income regime could disadvantage those outside the corporate sector. Goodwill often accounts for a substantial proportion of the total gain on the sale of a business and the loss of taper and other capital gains reliefs would lead to a significantly higher tax charge.
1.12 Secondly, closer alignment with accounts could make compliance more difficult for individual owners of intangibles who are not in business and so would not ordinarily prepare accounts. Limiting the reform to corporation tax would avoid this problem.
1.13 The Government recognises that this would have the disadvantage that the benefit of modernised rules would not be available to non-corporate owners of intellectual property and other intangible assets. So while this Note is written on the basis that the options it explores would apply for corporation tax only, we would be interested to hear views from respondents who think it important to extend the reform to income tax.
Deduction at source on royalty payments
1.14 At the time of the March 2000 Budget, the Government also announced that 'there will be consultation later in the year about modernising the rules for deduction at source from royalties. The aim will be to make it easier for businesses to get access to the intellectual property on which improving competitiveness will increasingly depend'. Chapter 6 of this Technical Note looks at the options.
Aim of this Note
1.15 The purpose of this Technical Note is to ensure that businesses and taxation practitioners have the opportunity to assess the impact of an extended reform potentially covering all the assets within the scope of FRS10. Comments are invited both on the specific questions asked in the Note and more generally on the desirability of reform.
1.16 This Note is being published in parallel with the Technical Note on capital gains deferral relief for substantial shareholdings. In both cases, the Government currently intends to publish draft clauses for consultation around the time of the Pre-Budget Report and to legislate in Finance Bill 2001.
Compliance costs
1.17 Reform in this area offers an opportunity to cut compliance costs. A draft Regulatory Impact Assessment will be published alongside any draft legislation. At this stage, initial views are invited on the effect on compliance costs, and how such costs might be minimised in the design of the reforms.
Which approach?
2.1 The first issue which needs to be resolved is the kind of scheme which best meets the objectives behind the proposed reforms. The March 1999 Technical Note Reform of the taxation of intellectual property set out two basic options: a uniform and comprehensive regime based on capital allowances, or a more radical reform which would align tax and accounting treatment. The Note expressed a preference for the latter, and this was largely supported by those who responded.
2.2 However, that Technical Note considered reform only in the context of intellectual property. With the reform potentially taking in all intangibles and goodwill, the Government believes the opportunity should be taken to canvas views on the full range of options. The aim is to: · be as simple as possible; · be flexible enough to meet the needs of a fast changing world; and · ensure that Government's competitiveness agenda is fully supported.
Capital allowances or accounts based?
2.3 There has been a growing trend towards the alignment of tax and accounting profits. This can be seen both in a series of recent court decisions and in specific legislation such as that on corporate debt and, in the field of intangibles, in the Finance Bill 2000 legislation on spectrum licences and telecommunications cable capacity rights.
2.4 So one option would be to take this further and base the new regime as closely as possible on the accounts treatment. An accounts based regime would reflect commercial outcomes more closely, with the tax and accounting treatment of intangible assets, income and expenditure aligned. The capital-revenue divide would disappear. An accounts based regime would also:
2.5 An alternative would be a capital allowances regime with its own free-standing rules and fixed rates of write off. This would mean the retention of the capital-revenue divide. It could also be harder to achieve the simpler and more flexible system which it is hoped will come out of any reform. Nevertheless, capital allowances rules are familiar and long-established and there could be advantages in applying them here
2.6 It would also be possible to adopt a hybrid approach. For example, even if the greater certainty of fixed rates of write off were felt to be of benefit to both businesses and the Exchequer (see the discussion below), it ought still to be possible to achieve closer alignment with the accounting treatment by following accounting definitions and including intangible assets and goodwill fully within an income regime.
Which assets?
2.7 The 1999 Technical Note considered reforms in terms of defined "intellectual property" assets only. This had the disadvantage of maintaining difficult borderline issues between 'intellectual property' (however we choose to define it) and other intangible assets. Intellectual property is not recognised as an accounting concept and making the distinction would inevitably lead to potentially complex and time-consuming disputes. As already noted, FRS10 provides a focus for the redesign of the rules in this area. And one of the advantages of a broader reform is that the tax system will not give businesses an incentive to do more in terms of accounting than they need to do under FRS10.
2.8 The Government does not rule out limiting reform to defined intellectual property assets only. But doing so would miss an opportunity for radical modernisation which would maximise the advantages of an accounts-based reform and better equip the tax system to cope with a business environment in which the economic importance of intangibles is growing.
2.9 The Government would also like to look at the opportunity for a broader modernisation of the rules to take in certain expenditure which is expensed in business accounts (because in accountancy terms it does not produce any recognisable asset) but which is not normally tax deductible because, in tax law terms, it gives rise to capital assets of an intangible nature. This issue is discussed in greater detail in chapter 3.
Rates of amortisation
2.10 The Government can see significant simplification and modernisation gains in following the accounts treatment. But allowing businesses discretion in the amortisation rates adopted raises some possible problems.
2.11 With large, publicly quoted companies, market constraints ensure that companies in general write off the value of their intangible assets at rates that reflect their useful life. Evidence suggests that most businesses (including those privately held which are not subject to the same market disciplines) are currently amortising goodwill and other intangible assets over 20 years, the longest life ordinarily permitted under FRS10. This is consistent with the spirit of FRS10 which requires assets to be written off over their useful lives on a prudent but not unrealistically short basis.
2.12 However, the availability of tax relief may lead to this discipline being eroded - and the accounting standard undermined - as investment analysts recognise the cash-flow benefits of obtaining accelerated tax relief. This is particularly so given the increasing importance of EBITAD (earnings before interest, tax, amortisation and depreciation) in the market. There is clearly a tension here which needs to be explored openly. Two issues need to be addressed:
2.13 The alternative, if businesses' own amortisation rates cannot be utilised, would be for some kind of hybrid scheme. This would aim to match FRS10 in terms of identifying the assets to be brought within the new scheme. But it would ignore businesses' own choice of amortisation rate. There are likely to be considerable practical difficulties in trying to make distinctions between different types of intangible asset with specific fixed rates of amortisation for each, because of the need to define each asset class. So one option would be to adopt a single fixed amortisation rate for all intangibles. It would also be for consideration whether assets with indefinite economic lives should be amortised under this arrangement for the sake of simplicity or whether they should not be amortised at all.
2.14 The impact on compliance costs will be a key consideration when designing any new rules. We will need to consider whether a process can be designed which provides the Revenue with the necessary assurance that the rules have been correctly applied, while minimising compliance costs for both sides. This need not be constrained by existing procedures.
Questions
2.15 Do you agree that moving closer to the accounts is the right way forward in this area? If you think that capital allowances would be preferable, please say why. Or would you prefer some form of hybrid solution?
2.16 Do you agree in principle that an accounts based reform should apply to the full range of intangible assets and goodwill within FRS10?
2.17 Are there benchmark rates for amortisation which businesses would expect to adopt, if the reform followed FRS10 in full?
2.18 What assurance would there be that any benchmark rates were, by and large, adopted, or that tax would not drive down estimates of useful economic lives?
2.19 Would it be preferable for a single fixed amortisation rate to be set? If so, what should this rate be? Are there any other alternatives, and how would they be put into practice?
2.20 What practical arrangements would minimise compliance costs? And are there particular aspects of these proposals which might impose new burdens?
3.1 This chapter examines some other issues affecting the shape of any new regime.
Legislative approach
3.2The basic propositions of the reforms could be enacted by following the approach that has been adopted in the current Finance Bill with the provisions on spectrum licences and telecommunications cable capacity rights or 'indefeasible rights of use' (IRUs). This would specify that the tax treatment, in the case of intellectual property, goodwill and other intangible assets, will follow correct accountancy treatment. It would apply to the computation of corporation tax profits. An alternative approach would be to embed 'following the accounts' for intellectual property, goodwill and other intangibles in a specific set of tax rules. This kind of approach was used in the loan relationships legislation in Finance Act 1996.
Abolishing the capital/revenue divide
3.3 The Government sees the abolition of the capital/revenue distinction in this area as one of the major benefits of an accounts based reform. Removing this distinction, and aligning tax and accounting profit, would reduce tax compliance costs for both business and the Revenue. It should also make the system fairer because the distinction gives rise to 'tax nothings' (business expenditure for which no relief is available) and to avoidance opportunities as transactions are structured to give rise to revenue deductions and capital receipts.
3.4 An accounts based system would follow FRS10 so that all expenditure on intangibles would be allowed for tax as it was written off in the accounts. FRS 10 defines 'intangible assets' as: 'non-financial fixed assets that do not have physical substance but are identifiable and are controlled by the entity through custody or legal rights'. Where assets meet this test and appear on the balance sheet, the tax treatment could readily follow the accounts.
3.5 In some cases, expenditure on intangibles will not result in any balance sheet asset, for example because FRS10 does not, except in limited circumstances, permit capitalisation in the case of internally generated assets. In many cases, the expenditure in generating these assets will have been allowed for tax as it was incurred and debited to the profit and loss account. But in others, tax law will treat such expenditure as capital (and so not allowable), for example on the grounds that in tax terms it gives rise to an 'enduring asset or advantage of a capital nature'.
3.6 The Government thinks that it would make sense to try to modernise the rules in this area as well. Otherwise relief will be given for something that an accountant identifies as an intangible asset, but not for something that only an Inspector would identify as an intangible under principles established in case law. Because this goes further than FRS10, it would contribute more substantially to the elimination of "nothings". There will also be additional cost, as these kinds of expenditure are unlikely to be matched by additional tax receipts on related income (it is usually taxed already), and this will be a factor in determining the scope of any changes. Furthermore, it may prove difficult to frame an extension beyond FRS10 which addresses "intangible nothings" only.
3.7 Similarly, it should follow that any costs incidental to the generation or acquisition of intangibles and any abortive acquisition costs should also be treated in line with the accounts. Additional work may be needed for example to apportion the costs of an aborted acquisition between intangibles and other elements of the transaction. But this disadvantage is likely to be small by comparison with what is to be gained by reducing the scope for argument over what is tax deductible.
Groups of companies
3.8 UK corporation tax is based on the profits of individual companies and not on the consolidated profits reported by groups. The accounts entries that will be relevant for the tax treatment of intangibles and goodwill will be those recorded in the accounts of individual companies and not those in group consolidated accounts.
3.9 This means that, like other consolidation entries, consolidated goodwill (in effect the difference between the value of the identifiable assets of subsidiary companies bought and sold by the group and the total acquisition or disposal consideration) will not figure in the computation of tax profits. It is not intended that relief should be extended to consolidated goodwill, even if this is 'pushed down' to individual company level, either by legitimate accounting practice or by any tax avoidance device. The new regime may need to include a specific safeguard against this.
3.10 It would also be for consideration, in the context of a regime that followed the accounts, whether to build in a safeguard to prevent groups from writing off assets at a faster rate in the individual company accounts (which matter for tax) than in the consolidated accounts (which matter for the market). A safeguard of this sort is included in the current Finance Bill provision on spectrum licences and capacity rights in telecommunications cables.
Intra-group transfers
3.11 Another issue is whether special rules would be needed in the case of transfers of intangible assets between members of a group of companies within the UK. For example, there may be grounds for stipulating that such transfers should take place at market value or on a "tax neutral" basis.
Cross border transactions
3.12 In theory, there is no reason why cross-border transactions should be treated differently from wholly domestic ones under a reformed regime nor why cross-border, intra-group acquisitions should be treated any differently to third party acquisitions. But there may be grounds for a safeguard in cases where no economic benefit is generated in the UK.
3.13 When intangible assets are acquired from outside the UK the price paid ought to reflect the wealth generating capacity which the acquirer expects to realise in the UK. If the benefits accrue elsewhere, then the UK should not necessarily give relief. Transfer pricing rules will of course operate to limit any potential abuses. But in some situations, application of the rules would be cumbersome and there is not always full redress in current legislation where affiliates undertake a transaction that third parties would not.
Exit charge
3.14 There is a risk that having obtained relief a company will attempt to realise the value of its intangibles outside the UK tax net. This might be achieved where the company changes its residence status or ceases to employ the assets in a trade carried on through a branch or agency in the UK. An exit charge may be needed to prevent companies from doing this. If based on the existing capital gains rules, the charge would be on the market value of the assets concerned.
Other issues
Bundled assets
3.15 Rules would also be needed to deal with the situation where intangibles were bought or sold in a package with other assets. The rules would need to ensure that it was not possible to manipulate transactions (for example between associates and in cross-border situations), while keeping compliance burdens to a minimum in the case of fully commercial transactions. One option would be to follow the current capital allowances and capital gains tax models which provide for a just and reasonable apportionment in appropriate cases (Section 150 CAA 1990 and Section 52 (4) TCGA 1992).
Items not hitting the profit and loss account
3.16 The aim of an accounts based regime would be to follow the profit and loss account entries for tax as closely as possible. But there would be a need to ensure that all 'income' and 'expenditure' is properly brought into account. This may mean that rules would be needed to ensure that any such amounts are taxed or relieved whether or not they actually hit the profit and loss account. An example might be an amount credited or debited for whatever reason to a revaluation reserve. Such a rule would not just prevent manipulation and avoidance but equally ensure that a proper measure of relief was available in special circumstances where the correct accounting treatment for a particular cost did not involve a profit and loss account entry.
An "unallowable purpose" test
3.17 Although a number of issues have been described for which it might be possible to put in place bespoke safeguards, a new system could present wide ranging opportunities for abuse which could not be addressed individually. So there may be a case for a general protection. This might be modelled on the rule in the loan relationships provisions in paragraph 13 Schedule 9 FA 1996. That rule excludes from relief payments with a tax avoidance purpose.
3.18 The Government recognises that there is a balance to be struck. Safeguards will be necessary to prevent abuse of the system. However, these should not be such as to effectively restrict the value of the new system in facilitating genuine commercial activity. It would also be helpful to have examples of the kinds of transactions that safeguards ought, or ought not, to block.
Questions
3.19 The reforms could be implemented through free-standing rules modelled on the loan relationships approach, or the rules could be modified to follow the relevant accountancy treatment. Which alternative do you prefer, and why?
3.20 Some expenditure on "intangible" nothings might still be classed as capital under case law. How do we define this kind of expenditure? Precisely what kinds of nothings would you expect to be swept up? Where should we draw the boundaries? How easy will these be for IR and businesses to navigate?
3.21 What safeguards, if any, do you think would be needed?
3.22 Comments on any of the issues raised above, or on any other special situations where you consider specific measures are needed would be welcomed.
4.1 Introducing a new tax regime in this way inevitably raises difficult transitional issues. Finding solutions will involve striking a balance between recognising companies' existing expectations and the need to contain costs within reasonable limits (particularly in view of the risk of forestalling).
4.2 It is sensible to begin by distinguishing three types of intangibles:
Options for transition - purchased intangibles which do not attract capital allowances
4.3 The treatment of these assets will give rise to difficult issues both with regard to relief for amortisation and the tax treatment on sale.
Amortisation
4.4 One approach would be to leave existing assets completely out of the new regime until the point of disposal. An alternative would be to bring in existing assets at their balance sheet value at the commencement date and to allow amortisation relief from then on in accordance with the accounts. In theory, the latter approach should allow for a simpler transition as tax computations could follow the accounts from the outset and there would be no need to make adjustments for the amortisation charge on 'old' assets. But it would also carry the risk of significant tax loss unless there were anti-forestalling provisions to stop companies exploiting the new relief by rearranging or revaluing assets or adapting their accounting policies.
Disposals
4.5 The likelihood is that all sales of existing assets after the commencement date will need to be within the new regime. This will avoid a prolonged transition and reduce the need for complex safeguards against forestalling. In many cases, these sales would currently be within the capital gains regime. If capital gains treatment was allowed for the seller but income relief was available for the buyer the cost would be prohibitive.
4.6 But if these sales are to be taxed as income, provision will be needed to allow for the fact that no relief or only partial relief has been given for the cost. If amortisation relief is not allowed for pre-commencement assets, then no relief will have been given before the point of sale for their cost. If these assets are brought in from the commencement date at their balance sheet value, then no relief will have been given for that part of the cost written off before commencement. In either case, an adjustment could be made on the sale of the asset in recognition of the otherwise unrelieved cost.
4.7 Either historic cost or capital gains base cost could be used for this purpose. This would have the advantage of providing a measure of relief using an established figure and avoid the need for valuations which would involve increased compliance costs and operational difficulties.
Options for transition - home grown intangibles
4.8 In the case of existing home grown intangibles, there will be no value shown on the balance sheet on the introduction of a new regime and any 'cost' of creating the assets will generally have been allowed as income. In theory, therefore, there should be no problem applying an income regime to the disposal of these assets from the outset. In some cases, disposals would in any case have been taxed as income under current rules. However, in other cases, the government recognises that in the short term, at least, some expectation of capital gains treatment on disposal may exist and some transitional relief may be appropriate.
Options for transition - assets within capital allowances regime
4.9 If a straightforward way of bringing existing assets into the new regime from the outset could be found it would avoid the need for a complex and long-lasting transition.
4.10 One option would be to remove these assets from the capital allowances pools at their balance sheet value. Thereafter amortisation would be allowable and sales taxed as income. This option has the advantage of getting straight to a 'follow the accounts' regime and also of being closest to commercial reality. The old rules would be obsolete so the law would be simpler. In some cases, balance sheet values will be less than the pool value of the assets (particularly software which is often written off straight away in accounts) and relief will be accelerated. In cases where the capital allowance rate is generous by comparison with the useful life of the asset, a tax liability would arise as 'excess' allowances were clawed back.
4.11 An alternative option would be to have a hybrid of the old and new regimes. Existing capital allowance pools would be frozen and written off on a straight line basis over a set period (say, 5 years). When assets were sold, the proceeds would be taxed in full as income. Taxpayers would have to identify old assets separately in order to disallow the relevant amortisation charges which would involve additional complexity.
4.12 A further option would be to allow the old and new regimes to run in parallel. Existing assets would continue to be within the capital allowances regime with any excess of sale proceeds over cost being charged as a capital gain if the old rules so provided. Maintaining two regimes for a long period would increase complexity. Taxpayers would again have to identify old and new assets because sale proceeds of old assets would be within the capital allowances rules and amortisation of old assets would not attract relief against income. Since sales of assets into the new regime would be taxed under the capital gains rules where appropriate, this approach would be expensive. And there would need to be special rules to prevent people taking advantage of the differences in the two regimes.
Other assets
4.13 We think it should be possible to bring assets, such as copyright, IRUs and spectrum licenses, which are already dealt with on revenue account into the new rules without complicated transitional rules.
Questions
4.14 Should amortisation relief only be available for new acquisitions? Or should it also apply to existing assets? If so, what measures would be reasonable to prevent forestalling?
4.15 What transitional rules do you think are needed for each category of assets?
5.1 Although the main body of the ideas set out on this Note are designed to apply to corporation tax only, there are some issues which would also (or in one case exclusively) apply to income tax.
The charge to tax
5.2 The main focus of this Technical Note is the tax treatment of intangible assets, rather than income (royalties) from those assets. For taxpayers within corporation tax, a consequence of following the accounts would be that the accruals basis would apply to such income. Royalties from a UK source paid to persons outside the corporation tax charge would continue to be taxed under the existing rules applying to the various cases of Schedule D. However, we recognise that the scope of the UK charge to tax on some royalty payments will remain uncertain because it may not be clear whether there is a UK source.
5.3 Of course, questions about the existence of a UK source are relevant to other areas of tax law: especially in relation to interest. In the context of this exercise, it would be possible to explore whether there was scope for clarifying the existing position in so far as it relates to income from intangible assets. For example, it would be possible to consider whether the right to claim a deduction in calculating UK tax would give rise to a UK source. Alternatively, there may be advantages in leaving this issue to one side at present with a view to considering whether something might be done to clarify the UK source rules in a wider context. Is this likely to be the best approach? Or should we try to address the issue in terms of royalties alone as part of this exercise?
Expenses of non-residents
5.4 In the case of royalty income received by non-residents (other than in the course of a trade carried on by a branch or agency in the UK), we would need to consider whether the charge to tax should be on the gross amount of income or whether a deduction should be allowed for any expenses incurred in earning the income. This issue will only be significant in cases where the income is not exempt under a double tax treaty.
5.5 Under current rules, it is possible to claim expenses where the non-resident's income is charged to tax under Case VI of Schedule D, rather than under Case III as pure income profit. This is largely a theoretical issue since, in practice, transactions are structured in such a way that deduction at source does not have to be made. But a more coherent definition of payments from which deduction at source is required (along the lines discussed in Chapter 6) might make the question of expenses more significant.
5.6 There will be circumstances where a non-resident recipient of a royalty payment from the UK could have incurred genuine expenses. The payee might, for example, be a business receiving the payment in the course of a trade carried on elsewhere in the world in respect of which it was not taxable in the UK because it did not have a branch or agency here.
5.7 Nevertheless, denying deductions to non-residents would be in accordance with the normal principles of international taxation. The country in which the payee was resident would subject the income to tax. The primary responsibility for taking account of expenses should lie with that country and that country will normally give credit for tax deducted. Where the income flow is the other way round, the country of source does not generally allow a deduction for expenses to a UK payee but the UK gives credit for the foreign tax.
5.8 Any changes here would not affect the existing exemption for agent's commission in respect of copyright payments paid abroad which we propose to retain.
Charges on income and unpaid accruals
5.9 The Government is also considering whether to modernise the system further by removing the charges on income rules that currently apply to royalty payments. These rules limit tax deductions for royalties to the sums actually paid (rather than accrued) in a given year. Royalty payments would thus be brought into line with other business expenditure. This change could apply to income tax as well as corporation tax.
5.10 There may however be a need for a safeguard where accrued expenditure remains unpaid for a long period of time. One approach would be to follow the model adopted for the purposes of the loan relationships legislation and to deny deductions in certain circumstances where accruals remained unpaid after 12 months.
Income spreading
5.11 The 1999 Technical Note suggested abolition of the special rules which allow spreading of income derived from patents and copyright. Respondents were generally content that the rule on spreading of sums derived from patents could go. But there was substantial opposition to removing the rules for authors and artists.
5.12 Subsequent research has shown that the rules for authors and artists are very little used (perhaps 200 or so claims a year) and that the computations (which involve detailed analysis of the income) are complicated. The reliefs are poorly targeted since they are based on the length of time taken to produce works rather than whether there are, in fact, significant variations in income from year to year.
5.13 All these are good reasons for abolishing the relief but an alternative might be to replace them with a relief on the lines of farmers' averaging (S96 ICTA88). Under this rule farmers can claim to be taxed on the average of their profits for two tax years. A relief of this sort would be better targeted since the relief depends on variations in income and would enable more people to claim (since there would be no condition about the length of time taken to produce the work). It would also be easier for taxpayers and for the Inland Revenue to administer. But it would be more costly than the present reliefs.
Questions
5.14 Is there an immediate need to clarify the UK source rules for royalties?
5.15 Do you agree that non-residents should not get a deduction for expenses apart from agent's commission?
5.16 Should the spreading rules for patents and copyright be replaced by a new averaging provision?
6.1 This chapter looks at ways of making the rules for deduction at source more coherent and improving the procedures for giving relief due under double tax treaties. It takes account of the responses to the discussion on deduction at source in the 1999 Technical Note 'Reform of the Taxation of Intellectual Property'.
The scope of deduction at source
6.2 The main purpose of deduction at source is to collect tax that cannot be collected effectively or efficiently by assessment. This is particularly the case for payments which cross an international border where deduction at source may be the only way in which the tax can be collected.
6.3 The existing rules for deduction at source from payments in respect of intellectual property are out of date, complex and can be difficult to apply. In particular:
6.4 Under existing rules, deduction at source in respect of intellectual property applies to:
6.5 Deduction at source does not apply, however, to other payments in respect of intellectual property, for example cross-border payments for the use of trade marks which are not pure income in the hands of the payee. Some of these payments are difficult to distinguish from those to which deduction does apply.
6.6 In view of this uncertainty, there may be good grounds for introducing a new and more coherent definition of the intellectual property payments to which deduction at source would apply. This could provide greater certainty and clarity for both UK businesses and the Revenue and would make the collection of tax which is due more effective.
6.7 An option which attracted support in the earlier consultation would be to draw on Article 12 of the OECD's "Model Tax Convention on Income and Capital". This defines royalty payments as follows:
"payments of any kind received as a consideration for the use of, or the right to use, any copyright of literary, artistic or scientific work including cinematographic films, any patent, trade mark, design or model, plan, secret formula or process, or for information concerning industrial commercial or scientific experience".
6.8 This definition is internationally recognised and it is consistent with most of our tax treaties. One feature of the OECD definition is that it applies only to payments for the use of, or the right to use, intellectual property. It does not apply to payments for the acquisition of such property.
Exceptions
6.9 In principle there should be no need for deduction at source where UK tax can be collected effectively and efficiently by assessment. This will generally be the case where the payee is resident in, or operating in, the UK.
6.10 This means that there should be no need for deduction at source where the recipient of the royalties is within the charge to UK corporation tax on the income or is an individual who is beneficially entitled to the income and whose normal place of abode is in the UK.
6.11 The main circumstances in which UK tax might be lost where cross-border royalty payments are made are where the payer obtains a tax deduction for the payment but no tax liability can be enforced on the recipient. There is considerably less vulnerability where the payer does not obtain a tax deduction. There would also be significant practical difficulty in attempting to apply deduction at source where the payer was an individual making a payment (for example to download software) for personal use.
6.12 This suggests that the requirement to deduct at source from royalty payments should be limited to cases where the payment is made in the course of an activity the income from which is subject to UK tax. It would be necessary to include payments made through agents.
6.13 There are currently a number of exemptions from the requirement to deduct at source. These include film royalties (as a result of an exemption introduced in 1927, when the film industry was in its early days) and the 'professional exemption' which applies, under certain circumstances, to royalty payments to authors. If new rules were introduced based on the OECD definition, it would be for consideration whether or not provision should be made to retain these exemptions. Either way, our wide network of double taxation agreements would ensure that most payments would still flow without deduction at source or with deduction at a reduced rate.
Relief under double taxation treaties
6.14 In the international context, the UK has a source based approach to the taxation of royalties. This means that we have taxing rights over royalty income from a UK source subject to relief being available under the terms of a double taxation treaty. Under many of our treaties, we have given up or limited our taxing rights on royalty income where the beneficial owner is a resident of the other state. This is subject to certain rules to prevent abuse.
6.15 As part of the drive to ensure that UK businesses can make effective use of the intellectual property they need, and to minimise compliance costs, the Government wants to consider whether the procedures for giving relief due under a treaty can be improved.
6.16 At present, a payer must deduct at source at the full rate if the payment is within the scope of the rules unless treaty relief has been authorised by the Inland Revenue. This authorisation follows an application which has been made by the beneficial owner of the royalty income which has been endorsed by the beneficial owner's tax authority. Where a payment is made to which deduction at source has not been properly applied, the Inland Revenue can recover the tax at stake, together with interest, from the payer. However efficiently such a system is operated, the need to involve the beneficial owner, the beneficial owner's tax authority and the Inland Revenue before a notice can be issued to the payer can give rise to delay and administrative cost.
6.17 The aim of any reform of the procedures would be to reduce this burden on payers, while ensuring adequate compliance. In some cases at least, businesses would want assurance that they were not exposed to the risk of recovery of tax if they made a payment without deduction at source and it was later found that treaty relief was not due.
6.18 Ensuring adequate compliance would require:
6.19 It follows that to give complete assurance to payers that they were not exposed to recourse for tax due from the beneficial owner, some sort of acceptance would be needed from the Inland Revenue that treaty relief was due, and that acceptance would be required at the time the payment was made. In some cases, however, payers might be prepared to accept the risk, for example where time was critical or in the light of their relationship with the recipient.
6.20 The Government would like to explore, in consultation with interested parties, what improvements could be made to the existing procedures which would achieve these objectives. The possibilities which might be explored include:
Questions
6.21 Do you agree that the OECD definition provides the best means of determining the payments to which deduction should apply? If not what are the alternatives and why?
6.22 We would welcome comments on the case for continuing existing exemptions from deduction at source, such as those for film royalties and certain payments to authors, in the context of a reformed regime.
6.23 Should the system for obtaining treaty relief be streamlined and if so how?
Annex: International comparisons
A.1 A number of other countries allow relief for purchases of goodwill and other intangibles. The detail of the rules varies. Examples of the approach adopted elsewhere - Germany, the Netherlands and the United States - are summarised below.
Germany
A.2 Under the German tax code, depreciation of business assets is compulsory. Mandatory depreciation rates are set out in official tables issued by the Federal Ministry of Finance. Although there are different tables for different industries, the rates applying to intangible assets are common to all and operate on a straight line basis. The main rates of annual allowance are:
A.3 Profits on sale of intangible assets are taxed at normal corporate income rates.
Netherlands
A.4 The Netherlands tax code similarly provides for compulsory depreciation of business assets. Depreciation is given once an asset is brought into use, rather than from acquisition. Different depreciation methods are allowed, provided they are applied consistently and without regard for probable tax consequences. They must also conform with "sound business practice". This rule uses generally accepted accounting principles as its reference point.
A.5 Depreciation rates are based on the estimated useful life of the asset, and are generally given on a straight-line basis. If it can be shown that the usefulness of the asset is considerably higher in earlier years than in later ones, a declining balance method may be used.
A.6 There is no specific information about rates used in practice for patents or licences. Purchased goodwill is usually amortised over a period of 3 to 5 years. This appears to have been consistent with the old International Accounting Standard 22 (IAS22) on "Business Combinations" which adopted 5 years as the presumed useful economic life of goodwill and intangible assets. IAS22 has since been revised, and the presumed economic life of goodwill is now 20 years.
A.7 On sale, any profit is taxed as ordinary corporate income.
United States
A.8 The rules governing the tax treatment of intangible property are set out in great detail in Section 197 of the Internal Revenue Code. This defines qualifying intangibles, and allows purchases of such intangibles to be amortised over 15 years, beginning with the month of acquisition, and regardless of their actual useful life.
A.9 No amortisation is given for "self created" intangibles, and there are a number of anti-avoidance rules. The classes of assets which qualify include: patents, copyrights, formulas, processes, designs, patterns and know-how, goodwill, going-concern value, workforce in place, information base, customer based intangibles, supplier based intangibles, as well as licences and other rights granted by government.
A.10 Some intangibles are excluded from this regime (for example, computer software which is readily available for purchase by the general public). But amortisation may be allowed instead for such assets under the ordinary depreciation rules at Section 167 of the Internal Revenue Code.
A.11 Profits on sale of intangible assets amortised under Section 197 over and above amortisation recovered, which is treated as income, are taxable as capital gains.
Comments are invited on the issues raised in this Technical Note and should be sent to:
Jon Sherman
Inland Revenue
Business Tax Division
Room 312
22 Kingsway
LONDON WC2B 6NR
e-mail: jon.sherman@ir.gsi.gov.uk
to arrive no later than 11 August 2000
In accordance with the Inland Revenue's Code of Practice on Consultation, once the outcome of the consultation is announced, we will make available, on request, responses to consultative documents, unless any respondent has asked for her or his comments to be treated as confidential. If you wish the whole of your comments, or your name and address to be treated as confidential, please say so when you return your comments.
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