Prohibition of deductions in respect of certain intellectual property – part 1

Sources:
SARS Interpretation Note 120
Section 23I of the Income Tax Act

Background

The use of intellectual property belonging to another person normally carries a charge in the form of a royalty. Usually, such payment received will fall within the recipient’s gross income and the payor will be allowed to claim a deduction under section 11(a) for the expenditure incurred in paying the royalty.

Instances arose in which self-developed intellectual property was sold or transferred to another party connected to a resident developer. The use of the intellectual property was then granted to a resident company and a royalty was paid for the use of the intellectual property. The connected person typically paid no tax or tax at a very low rate on the royalty income either by virtue of such persons being regarded as exempt institutions or non-resident taxpayers. These types of transactions were designed to reduce the group’s overall tax liability in South Africa by having the royalty taxed at a lower tax rate and for the resident company claiming a deduction for royalty payments at the higher tax rate. Section 23I was therefore inserted with the aim of preventing the avoidance of tax.

The Explanatory Memorandum on the Revenue Laws Amendment Bill, 2007, provides the following background to the introduction of section 23I:

“The disparity in tax rates levied on income between different parties often creates arbitrage opportunities. The purpose of these arbitrage opportunities is to shift income from parties fully within the tax net to parties wholly or partly outside the tax net. In the case of intellectual property, this result is mainly achieved by shifting the intellectual property from a fully taxable party to a party wholly or partly outside the tax net. This shift is usually designed so that the shift triggers little or no tax. After the shift, deductible payments are made from the fully taxable party (now the licensee) to the other party operating wholly or partly outside the South African tax net. In many instances, the tax
benefits have no corresponding impact on cash flow as royalty payments are simply returned to the licensee-payor in the form of dividends. Meanwhile, the tax deductions for the licensee-payor may be so large as to effectively wipe out the payor’s tax base.”

Essentially, section 23I prohibits, subject to certain exceptions, a deduction of any expenditure incurred for the right or permission to use intellectual property qualifying as “tainted intellectual property” and other expenditure which is directly or indirectly related to such expenditure.

“Intellectual property”
For a property to qualify as “tainted intellectual property”, it must meet the definition of “intellectual property”.

Under section 23I(1), “intellectual property” means any:

  • patent as defined in the Patents Act 57 of 1978. Section 2 of that Act defines a patent as “a certificate in the prescribed form to the effect that a patent for an invention has been granted in the Republic” including any application for a patent under that Act”;
  • design as defined in the Designs Act 195 of 1993. Section 1(1) of that Act defines a design as “an aesthetic design or a functional design”;
  • trademark as defined in the trademarks Act 194 of 1993. Section 2(1) of that Act states a trademark as other than a certification trademark or a collective trademark, means “a mark used or proposed to be used by a person in relation to goods or services for the purpose of distinguishing the goods or services in relation to which the mark is used or proposed to be used from the same kind of goods or services connected in the course of trade with any other person”;
  • copyright as defined in the Copyright Act 98 of 1978. Section 1(1) of that Act defines copyright as “copyright under this Act”;
  • patent, design, trademark or copyright defined or described in any similar law to that referred to in the above bullet points of a country other than South Africa; in the United Kingdom, for example, a creator’s artistic, literary, dramatic and musical work is protected by the Copyright, Designs, and Patents Act, 1988. By applying paragraph (e) of the definition of “intellectual property” in section 23I(1), these works will also be regarded as intellectual property as defined under section 23I.
  • property or right of a similar nature to those listed above.

A license is not considered to be “property of a similar nature” since it is merely a right to use intellectual property and does not enjoy any statutory protection; and

  • knowledge connected to the use of such patent, design, trademark, copyright, property or right.

The knowledge imparted must be connected to the use or application of intellectual property.

“Tainted intellectual property”

Intellectual property will be classified as “tainted intellectual property” if any one of the requirements listed in paragraphs (a) to (d) of the definition of “tainted intellectual property” are met. These requirements are considered below.

Paragraph (a)
Under paragraph (a), the intellectual property will be regarded as tainted intellectual property if it was the property of the end-user or of a taxable person that is or was a connected person, as defined in section 31(4), in relation to the end-user.

Paragraph (b)
To be considered tainted intellectual property under paragraph (b), the intellectual property has to be the property of a taxable person. This means that the intellectual property has to be owned by any person other than those specifically excluded in the definition of “taxable person”.

The developer of intellectual property who has transferred ownership of the intellectual property to another person will no longer be the owner. Instead, the person who has acquired the intellectual property will be the owner of the property. If the new owner meets all the requirements of the section to be regarded as a taxable person, the intellectual property will be considered tainted. In the case of a usufruct agreement, a limited real right is conferred on the holder of the usufruct, that is, the usufructuary. In such a transaction, while the right to use the asset is granted to a person, the ownership, or bare dominium of the property, does not transfer to the usufructuary. As such, the usufructuary cannot sell the assets, or in this case, intellectual property rights, without the permission of the owner.

Section 23I will therefore apply to bare dominium intellectual property schemes (usufruct schemes). These schemes involve the separation of the ownership of intellectual property by a taxable person (the bare dominium holder), from the income benefits derived from the granting of the right of use of the intellectual property to a taxable end user. Any tax advantage from the payment of associated royalties to a person who is not the owner of the intellectual property is eliminated through section 23I. No connected person relationship is required.

Paragraph (c)
Under paragraph (c), intellectual property will be tainted intellectual property if a material part of it was used by a taxable person in carrying on a business while the intellectual property was the property of a taxable person and the end user of the property acquired that business or a material part of it as a going concern. This determination must be done by taking into consideration all the facts of the particular case.

It is not a requirement for the taxable person who owned the intellectual property and the end user in this scenario to be connected persons in relation to each other. The aim of this paragraph is to prevent the stripping of a business of its intellectual property rights as part of a business takeover, which would have the effect of potentially permanently depriving the South African tax base of royalty income.

Paragraph (d)
Paragraph (d) was inserted to address concerns that an overly broad anti-avoidance provision in relation to research and development arrangements may discourage foreign companies from using South African subsidiaries as intellectual property developers. Paragraph (d) states that intellectual property will be regarded as tainted intellectual property if it was discovered, devised, developed, created, or produced by the end-user or by a taxable person that is a connected person in relation to the end user.

This paragraph requires that at least 20% of participation rights be held by the end-user together with any taxable person that is a connected person in relation to the end user in a person to whom an amount is received or accrues in relation to that intellectual property:

  • by virtue of the grant of use or right of use or permission to use that property (paragraph (d)(i) of the definition of tainted intellectual property); or
  • if the receipt, accrual, or amount is determined directly or indirectly with reference to expenditure incurred for the use or right of use or permission to use that property (paragraph (d)(ii) of the definition of tainted intellectual property).

20% requirement
In paragraph (d)(i) of the definition of “tainted intellectual property”, the end user together with any taxable person that is connected to that end user must hold at least 20% of the participation rights in a person who receives an amount or to whom an amount accrues by virtue of granting the use, right to use or permission to use intellectual property.

The prohibition of deductions under section 23I(2)

Section 23I(2) prohibits a deduction of:

  • any amount of expenditure incurred for the use of tainted intellectual property [section 23I(2)(a)]; or
  • any expenses which are determined directly or indirectly with reference to the expenditure incurred for the use or right of use of or permission to use any tainted intellectual property [section 23I(2)(b)], to the extent that the amount of expenditure does not constitute income received by or accrued to any other person or to the extent that the expenditure does not constitute a proportionate amount of net income of a CFC which is imputed to any resident under section 9D.

The prohibition of a deduction under section 23I(2)(a)

Under section 23I(2)(a), a deduction is prohibited in respect of any amount of expenditure incurred for the use of tainted intellectual property.

The prohibition of a deduction under section 23I(2)(b)

Under section 23I(2)(b), expenses determined directly or indirectly with reference to the expenditure incurred for the use or right of use of or permission to use any tainted intellectual property are non-deductible. This section seeks to prevent taxpayers from avoiding tax by stopping transactions in which royalty expenditure is converted into, for example, financial instruments.

In the types of transactions envisioned in section 23I(2)(b), the licensor of intellectual property may attempt to claim variable costs which are directly or indirectly associated with the use of the tainted intellectual property and which do not constitute income of the person receiving these payments.

Part two of this article will deal with “Exceptions to the general prohibition of deductions under section 23I(3)”, “Prohibition of deductions and CFCs [section 23I(4)]”, and “Definitions” under the applicable law.

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