Patents and Know-How

Commentary

Proceeds of disposition v. receipts for exploitation of patents

The disposition of a patent or other intellectual property will be on capital account (unless such property was acquired as inventory of a business or as an adventure in the nature of trade) whereas royalties received for the exploitation of such property will be included in income.

An amount received for the granting of a non-exclusive licence for the use of a patent will not be construed as proceeds for the disposition of property held on capital account, so that such amount will be included in income even if received as a lump sum or instalments of a lump sum (CIL, Rustproof, see also British Dyestuffs). Conversely, where a patent is held as capital property, a lump sum received for the granting of exclusive rights to use the patent in a specified geographical area likely will be a capital receipt (Imperial Chemical, Firth-Brearly, see also Porta Test). This can be the case even if the licence is for a relatively short period such as five or ten years (see Desoutter, British Salmson, Tyresoles.) Furthermore, even if the rights are disposed of in consideration for the payment of annual royalties (i.e., payments based on the extent of use) plus a lump sum, that lump sum may qualify as a capital receipt (Imperial Chemical, Porta Test, see also Tyresoles, British Salmson).

Government compensation received for past usage by the government of patents of the taxpayer will be income receipts (Mills v. Jones, Constantinesco).

Capital property v. inventory

Patents very well may be capital property to the taxpayer if its practice is to exploit its patents by licensing them for periodic royalties rather than disposing of them (Firth-Brearly). On the other hand, if the disposition of patents is a normal incident of its business, such dispositions likely will be on income account (see Rees Roturbo).

Although by analogy with the tax treatment of the exploitation of Copyright, a taxpayer whose business was to develop patents with a view to disposing of such patent rights would realize the resulting receipts on income account, an amateur inventor very well might be able to dispose of the inventor's invention on capital account (see Dauphinee).

Receipts for exploitation of know-how v. disposition of business

Sums received by a taxpayer for imparting know-how generally will not qualify as capital proceeds for the disposition of a capital asset since the taxpayer will continue to retain the know-how which it imparted (English Electric), and given that such a transaction can be characterized as receiving a reward for the service of "teaching" the recipient of the know-how (Rolls-Royce). An exception to this rule may apply where the know-how is being transferred as part of a disposition of the business to which it relates (Evans Medical), or perhaps where the effect of an exclusive licensing of the know-how would be to cause a loss of the business to which it relates (see CGE).

Capital reorganizations

Where patents have been held by a taxpayer as capital property on the grounds that it uses them in its business of earning royalties, a transfer of some of those patent rights to a subsidiary which will continue to similarly exploit them likely will be viewed as a capital account transaction (Firth-Brearly).

Cases

The Queen v. Canadian General Electric Co. Ltd., 87 DTC 5070, [1987] 1 CTC 180 (FCA)

A federal Crown corporation ("AECL") was the exclusive purchaser of the heavy water produced by the taxpayer and had decided to build a heavy water plant of its own upon the taxpayer declining an AECL request to double capacity at the taxpayer's heavy water plant. The taxpayer then received $1.5 million from AECL for the sale of its know-how respecting heavy-water production coupled with rights of first refusal in favour of the taxpayer in the event that AECL disposed of its new plant or required additional production of heavy water. The trial judge had found that although the taxpayer continued for a number of years to produce heavy water from its own plant, the effect of the above transactions was that the taxpayer's ability to make further use in Canada of its heavy water know how was terminated, so that the receipt was on capital account.

MacGuigan, J., in finding that the receipt was business income, stated (at p. 5074) that "it would be an improper inference to find that the respondent lost its business as a direct and necessary result of entering into the agreement with AECL", and that "the CIL case stands for the proposition that the sale of know-how will not normally be regarded as the sale of a capital asset, particularly when the sale is by a non-exclusive licence, and that any exception to this rule must be strictly established as a total loss of know-how which is a direct and necessary result of the licence agreement."

Dauphinee v. The Queen, 80 DTC 6267, [1980] CTC 332 (FCTD)

The rights to inventions made by the taxpayers vested in the federal Crown because they made the inventions within the scope of their employment as civil servants. They then received compensation payments from the federal government equal to 15% of various related royalties or other amounts received by the government in respect of their inventiobns.

Walsh J stated in obiter dicta (at p. 6271) that if "an invention made by an inventor in the employ of a Government department made entirely outside the scope of his employment ... [were] disposed of [by him] to a third party or to the Crown and it was a one time invention not made by him as a professional inventor [then] the proceeds of the sale might well be treated as a capital receipt." Such facts, however, did not exist, and the payments received by the taxpayers respecting their inventions were taxable remuneration under s. 5(1).

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Tax Topics - Income Tax Act - Section 5 - Subsection 5(1) 105

Canadian Industries Ltd. v. The Queen, 80 DTC 6163, [1980] CTC 222 (FCA)

The granting by the taxpayer to the U.S. government of a non-exclusive license to use patents concerning a process for the manufacture of TNT and the "know-how" concerning the process, in return for a lump sum calculated without regard to the extent of user, did not by itself result in a loss of the taxpayer's business of manufacturing TNT for U.S. military purposes. The lump sum accordingly was income. The "significance of the distinction ... between an exclusive and non-exclusive license" was also noted.

Porta-Test Systems Ltd. v. The Queen, 80 DTC 6046, [1980] CTC 71 (FCTD)

The taxpayer granted a U.K. company the exclusive right to manufacture, use and sell specified inventions of the taxpayer in the U.K. in return for the U.K. company's agreement to pay the taxpayer a royalty for the following three years equal to 5% of the net proceeds realized from the sale of the licensed products for that period, plus an additional sum equal to the excess of $150,000 over the amount of such royalties. Additional royalties were payable in subsequent years. Since at the time of signing this agreement it was anticipated that the true royalties (based on the extent of actual user) would not amount to $150,000, and the taxpayer instead was seeking an additional sum as compensation for the sale of its rights, the excess of $150,000 over the actual royalties of $75,000 received by the taxpayer in the first three years was held by Primrose DJ to be a capital receipt.

See Also

Murray v. Imperial Chemical Industries Ltd. (1967), 44 TC 175 (CA)

The taxpayer, which had been granted the exclusive world-wide licence to exploit the master patent for "Terylene" and was the owner of ancillary patents, granted to a Dutch company an exclusive licence of the right to exploit these rights and related know-how in the Netherlands and Belgian market in consideration for an annual royalty and, in addition, received a lump sum payment of £400,000 for its covenant not to enter those markets for the period of the patent. Since the £400,000 payment in essence was consideration for the granting of an exclusive licence of patent rights, i.e., for the disposition of a capital property, it was a capital receipt.

Musker v. English Electric Co. Ltd., 41 TC 556 (HL)

Sums received by the taxpayer for licensing its "manufacturing technique" for the Canberra Bomber to a number of foreign licensees were found to be receipts of its trade given that, in substance, it was receiving a reward for teaching and any diminution in the value of its know-how, when viewed as a capital asset, was far too speculative to be the basis for treating the transaction as the disposal of a capital asset.

Jeffrey v. Rolls - Royce, Ltd. (1961), 40 TC 443 (HL)

The taxpayer, which was a manufacturer of automobiles and airplane engines, received various sums pursuant to purported licences of know-how to foreign organizations. Generally, it supplied a large number of drawings and other information, and undertook to teach technicians from those countries and to send some of its own employees to supervise operations there.

In finding that the sums were receipts of the taxpayer's trade, Lord Reid noted (at p. 492) that "in essence, what it did was to teach the 'licensees' how to make use of the 'licences' which it granted and that this course of 'granting of licences' was merely an extension of its existing trade devised to meet the difficulty that it could not sell its engines in the countries of the 'licensees'. It was merely another method of deriving profit from the use of this technical knowledge, experience and ability,"

Evans Medical Supplies, Ltd. v. Moriarty (1958), 36 TC 207 (HL)

A lump sum received by a company that sold to the Burmese government a secret process upon which the success of its business in Burma had to depend was found to be a capital sum given that the company had, in effect, disposed altogether of its Burmese trade.

Rustproof Metal Window Co. Ltd. v. C.I.R., [1947] 2 All ER 454, 29 TC 243 (CA)

The taxpayer, which had acquired letters patent relating to a galvanizing process, granted to a manufacturer of ammunition boxes a licence to use the process within the United Kingdom to manufacture up to 75,000 ammunition boxes for a period of up to approximately 12 years, in consideration for a "capital sum" of £3,000 and a royalty of 3d. per box. Because the licence was a non-exclusive licence and the taxpayer's right to exploit the patent by the grant of other licences was therefore unimpaired, the £3,000 was an income receipt.

Magerison v. Tyresoles, Ltd. (1942), 25 TC 59 (KBD)

The taxpayer, which was the owner of a patented process for the re-treading of old tires, entered into agreements with a minimum term of five years with car dealers and garage operators under which it installed equipment for the re-treading operation on their premises in return for a fixed rental. In addition, the taxpayer agreed in consideration for a lump-sum payment not to install or permit the installation of another plant nor to canvass orders within the dealer's territory.

Wrottesley J. agreed with the finding of the General Commissioners that the lump-sum payments were capital receipts on the ground that the taxpayer had "parted with its freedom of action, its rights arising under its ownership of the patented process, for a certain limited period, for a certain limited area, and for a certain limited type of customer" (at p. 68).

British Salmson Aero Engines, Ltd. v. C.I.R. (1938), 22 TC 29 (CA)

The taxpayer, an English company, was not required to deduct income tax on a lump sum payable (in three instalments) to a French company for a 10-year licence under a patent to manufacture and sell airplane engines in the Commonwealth, because the exclusive nature of the licence rendered the payments capital in nature. However, additional annual royalties were subject to U.K. income tax.

Desoutter Bros. Ltd. v. J.E. Hanger & Co., Ltd., [1936] 1 All ER 535 (QBD)

The plaintiff granted a licence to the defendants for a period of five years to make and sell artificial legs pursuant to a patent of the plaintiff in consideration for a fixed sum of £3,000 (£1,000 down and the remainder by instalments). In finding such payments to be of capital, with the result that the defendant was not required to withhold income tax therefrom, MacKinnon J. noted that this was the case of a lump-sum entitling the defendants to make all or any use that they may choose of the patent and that the sum was fixed in advance of the anticipated use of the patent rights.

Mills v. Jones (1929), 14 TC 769 (HL)

The taxpayer received government compensation in respect of the past, present and future use by the British Government of the taxpayer's patent for the Mills' bombs. Given that the General Commissioners had found that (in view of the large stock of bombs on hand) it was improbable that there would be any further manufacture of the bombs prior to the expiration of the taxpayer's patent, the sums received by the taxpayer were substantially all in respect of past use of the patents and, accordingly, were income.

Rees Roturbo Development Syndicate, Ltd. v. Ducker (1928), 13 TC 366 (HL)

The taxpayer, which was formed for the purpose of acquiring and exploiting patents and licences and which licensed its patent rights to foreign manufacturers, typically with an option on their part to purchase, realized a taxable profit when such an option was exercised, given that such a dealing in patents should be considered to be part of its business.

Constantinesco v. Rex. (1926), 11 TC 730 (HL)

An award of £70,000 that the taxpayer received after the First World War in respect of the compulsory use of its patent for an interrupter gear by the British Government during the war effort represented an income receipt because the payment was made in respect of the use of the invention over a period of time and because the patent itself was not taken away by the government but still remained with the taxpayer.

Collins v. Firth-Brearley Stainless Steel Syndicate, Ltd. (1925), 9 TC 520 (CA)

The taxpayer, which was incorporated for the purpose of exploiting a patent for stainless steel which (by the time of the appeal to the Commissioners) had been granted to it in 28 countries, was found to have realized capital receipts when it transferred its American patent rights to an American subsidiary in consideration for shares, and sold the Japanese patent rights to a Japanese company for £25,000 payable in cash instalments (plus an annual royalty of £1,000, which it acknowledged to be taxable). The Commissioners were justified in finding that the taxpayer was not in the business of buying and selling patent rights given that in virtually all the other countries, it was exploiting its patents by licensing them. In addition, the American transaction was the "mere transfer of one capital asset into another form of capital asset" (p. 575).

Warrington L.J. also stated (p. 572) that the transaction:

"... is carried out in the form of a sale, but it really is the promotion of a subsidiary company to do for their own benefit and for the benefit of the parent company that which the parent company might have done if they had so pleased through agents or otherwise on their own behalf. It is not the sale by a man who is dealing in goods which he goes and sells in the open market or sells in the ordinary course of trade. It is a sale of a very special nature.

British Dyestuffs Corp. v. C.I.R. (1924), 12 TC 586 (CA)

The taxpayer and an American Company ("DuPont") entered into an agreement under which each undertook to communicate particulars of patents and secret processes to the other. Each company had the exclusive right to use the licensed know-how and patents within specified territories. The taxpayer was entitled to receive £25,000 annually for ten years provided that the information provided to DuPont led to the production of commercial products (and with royalties being receivable for the use of patents beyond the ten-year period).

Before going on to find that the £250,000 payable to the taxpayer were profits of its trade, Bankes L.J. stated (at p. 596) that the real question was: "Is the transaction in substance a parting by the Company with part of its property for a purchase price, or is it a method of trading by which it acquires this particular sum of money as part of the profits and gains of that trade?"

Administrative Policy

5 January 2012 External T.I. 2011-0412581E5 - Right to use a patent - eligible property

respecting a licensing by a Canadian corporation of the use of its patent for specified purposes for a limited period to another taxable Canadian corportion in consideration for the issuance of shares, CRA was asked whether such right to use the patent would qualify as eligible property under s. 85(1.1). CRA responded that to be an eligible property the property must be a capital property; and the question as to whether a dispostion of the patent right would be on income account was a question of fact which could only be determined after a detailed review.

1996 Ontario Tax Conference Round Table, "Purchase and Sale of Computer Software, Q. 5", 1997 Canadian Tax Journal, Vol. 45, No. 1, at p. 221

Where the development costs of computer software were claimed as a deduction under s. 37(1)(b), proceeds of disposition of the software will be on income account by virtue of s. 37(6).

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Tax Topics - Income Tax Act - Section 37 - Subsection 37(6) 30