In the last two Budgets, the Government did a lot of heavy tinkering with the rules on goodwill related intangibles. In the first Budget of 2015, they stopped tax relief when a company acquired such assets from a related party, and in the second, Summer Budget of 2015, they extended this treatment to unrelated parties. One would have expected the Big Bad Wolf to be satiated by now, but it seems not – Autumn Statement 2015 has given us yet another set of restrictions on intangibles related tax relief.
These new rules are designed to plug a gap in the existing provisions that determine when intangibles created before 1 April 2002, are to come within the corporate regime. The headline announcement makes clear that the new rules are aimed at the use of partnership vehicles to bring “old IP” into the new regime earlier than one would otherwise have expected – we shall see how in a moment. However, the draft legislation makes clear that these rules are not restricted to partnership situations.
In this article we shall use the term “IP” – short for intellectual property – to denote the various types of intangible assets covered by the corporate regime. Strictly, it isn’t just IP that’s covered – the regime also covers non-IP items such as goodwill.
(This article can be downloaded in pdf format at Academia.edu.)
Background – what are the IP rules all about?
The IP rules came into force on 1 April 2002, with the intention that for companies, the tax treatment would follow the accounting treatment. So a company that owns IP is able to obtain tax relief as the relevant asset is written down in the accounts. Conversely, IP related receipts are taxed as and when they are recognised for accounting purposes. All receipts and expenses are taxed as revenue, irrespective of the actual nature of the amount in question.
However, the rules do not automatically apply to all IP1:
- For IP created on or after 1 April 2002 – which we shall call “new IP” – the IP rules always apply;
- But for IP created before that date – “old IP” – the rules do not apply until the first sale or transfer to an unrelated party.
What is an unrelated party? Someone who is not a related party of course! And what is a related party? The legislation has a section devoted to this question2– but broadly, as the term suggests, two parties are related if there is a link between them. The most obvious example is that of two companies in the same group though surprisingly, this wasn’t the case when the legislation first came out.
The idea is obvious – old IP can only be transformed into new IP when its owner has sold or otherwise disposed of it, and no longer has any economic control or benefit over the asset. This is not the case if the asset is simply transferred to a related party such as a group company.
But there is – or rather, was – a gap in the rules on related parties. We shall now explore this in greater detail.
How can old IP be transformed into new IP? By using a partnership!
Consider the following scenario:
Suppose that A owns IP which was created before 1 April 2002, and is still within the old regime. A wishes to benefit from the tax relief that a company would be expected to obtain under the new rules but cannot. For example:
- If A is an individual, such as a sole trader in business, he can incorporate, but on transferring the IP, tax relief to the company is denied. The company is controlled by A and so the parties are related3;
- If A is a company, it cannot simply transfer the IP to a fellow group company or any other company over which it has control This is another related party transaction and so the IP remains within the old rules.
But what if a partnership were used instead?
A sets up a partnership, with two partners, the majority stake being held by a new company C. A may have control over C, or, if A is a company, A and C could even be the same person. The other partner can be a token member who holds a miniscule stake. For reasons that shall become apparent later on, we shall call the partnership “B”.
How could this work? This is the idea:
- The transfer of IP from A to B is not a related party transaction. This is because the rules governing what constitutes a related party make no mention of partnerships;
- B, the partnership doesn’t pay any tax – recall that partnerships are tax transparent. Instead, the partnership must work out its profits for the year and allocate a profit share to each member in accordance with his stake in the partnership4;
- In calculating C’s share of the profits, the legislation requires B to pretend that it is a company and not a partnership. And, if it were a company, it would be entitled to write down the value of the IP for tax purposes, in line with the accounts5;
- This tax write-down is transferred to C on receiving its profit allocation for the year. And so old IP is transformed into new.
- Note that this idea cannot work if the IP constitutes goodwill related IP. This is because since 8 July 2015, all tax relief is denied on goodwill related acquisitions, irrespective of whether a related party is involved or not6.
There is a possible flaw in this argument, which we shall come to in a moment. But first of all, taking a big picture view, this idea should not work at all. The diagram sets it out clearly. If there is a link between A on the one hand, and C on the other, how can anyone really argue that the economic benefit of the IP has changed hands?
It shouldn’t work, but the real test is what the legislation says.
So what does (did) the legislation say?
This idea depends on the fact that, until recently, a transfer from A to the partnership B, was not a related party transaction.
First of all, we need to look at CTA 2009 s 882, the section which tells us when a company can write down its IP for tax purposes. For old IP, it can only claim tax relief if the IP was acquired on or after 1 April 2002 in the following circumstances:
- By acquisition from a person who is “not a related party in relation to the company” – for example, where one company V simply sells its old IP to an “outsider” company B; or
- By acquisition from a person who is a “related party in relation to the company”, provided certain circumstances are satisfied. For example, V sells to unrelated party A, bringing the IP into the new regime. A then sells to fellow group member B. B can claim tax relief because the IP became new IP on the V-A transfer.
The key issue is: “Who is a related party in relation to the company?” And this is answered in CTA 2009 s 835 which sets out the various rules for determining when “a person A is a related party in relation to a company B.” (It should now become apparent why we labelled the various parties A and B in our diagram!)
And we can see the problem straight away. B is the party that acquires the IP in the legislation, and B must be a company. In fact, in the cases set out in the related party rules, A is also a company or an individual, but never a partnership.
So A and the partnership B cannot be related, and the transaction brings the old IP into the new rules.
What about that possible flaw in our argument that the transfer to the partnership is not a related party transaction?
There are two arguments to consider:
- When a partnership acquires an asset, it is on behalf of the partners or members. So the company C really has acquired the old IP, or at least an interest in the IP commensurate with its share in the partnership. And since A is related to C, the old IP must remain old IP;
- Alternatively, in calculating C’s tax liability we must pretend that the partnership is a company. So the related party rules can be made to apply after all. And by pretending that B is a company, we are sure to find that A and B are indeed related.
We shall look at these two arguments in turn.
It is actually C who acquires the IP, not the partnership
This is a superficially attractive proposition but it is not correct. If the partnership is an LLP it is patently false, as the latter has its own legal personality and the assets it acquires, it acquires for itself. The members have no property rights in the underlying assets. On the other hand, a standard partnership has no legal personality, but it doesn’t automatically follow that the partners have property rights in the underlying assets – all they have is a chose in action consisting of their partnership shares.
Note that there are in fact deeming provisions for LLPs which treat the dealings and activities of an LLP as being those of its members. At first, this would appear to support the argument that for LLPs at least, the acquisition of the IP is one made by the corporate member. However, the deeming legislation goes on to state that any references in the Corporation Tax Acts to companies specifically exclude LLPs7. This includes the references to “company B” in the related party provisions of CTA 2009 s 835.
Pretend that the partnership is a company so that A and B are related after all
This is also superficially attractive, but doubtful. What this argument does is to take a deeming provision in one part of the tax legislation, and apply it to another part. This is not allowed unless there is specific authority to do so.
In fact we have encountered this argument before in the capital allowance case of Drilling Global Consultant LLP v HMRC8. In that case, a corporate member of an LLP unsuccessfully tried to claim an annual investment allowance. One of its arguments was that the LLP was deemed to be a company by virtue of the provisions requiring this treatment for the purpose of calculating the profit shares of the corporate members.
But this deeming provision only applies for that particular purpose and no other. While the partnership must pretend it is a company for the purpose of writing down the acquired IP, this is necessary in order to calculate the corporate partner’s tax liability. But that’s where it stops – it isn’t necessary to extend the deeming provision to determining whether the partnership’s acquisition of the IP is a related party transaction.
How does the new legislation plug the gap?
The related party rules have been extended so that two parties are related to one another if one party is directly or indirectly participating in the management, control, or capital of the other9. This is a concept from the transfer pricing legislation and we shall see how it can be used to deal with the situation where old IP is transferred into a partnership.
However, a number of points immediately spring to mind:
- The extension to the related party rules is not limited to partnerships – the wording of the new legislation is general and wide enough to cover companies as well. But companies are already covered under the existing related party rules. Could it be possible that a person that was not originally related to a company (a real one), now be related by this new transfer pricing provision?
- The additional legislation is not where you’d think it would be, under the related party rules in CTA 2009 s 835. Instead, it is added in two places:
- The provisions to determine whether IP assets are within the corporate regime (amendments to CTA 2009 s 882); and
- The provisions that stipulate that related party transactions are deemed to be made on an arm’s length basis (amendments to CTA 2009 s 845)10.
What does this mean? It means that the extension to the related party rules is only relevant for these particular purposes and for no other. Without specific authority, the new definition does not apply where related parties are mentioned in other parts of the IP legislation – though in practice there aren’t that many other places11;
- The new legislation states that partnerships are to be included, but the inclusion is a limited one. One only applies the transfer pricing rules to determine12:
- Whether old IP has been transformed into new IP; and
- To fix the value of any transactions which are related party transactions;
And only for the purpose of calculating the corporation tax liabilities of the corporate members.
How do we apply the new legislation to partnerships?
The key question is whether A is directly or indirectly participating in the management, control, or capital of the partnership B.
For direct participation, all that is necessary is for A to have control of B, which in turn means that A must be entitled to either more than 50% of B’s income or more than 50% of B’s assets13. This will be satisfied if A and C happen to be the same person. But what is the position if A’s stake in the partnership is an indirect one? For example, what is the position if C is set up as a subsidiary of A?
In these circumstances one needs to consider the rules governing when a person indirectly participates in the management, control or capital of the partnership. There are a number of complex subrules14, but the one that closely fits this situation is where15:
- C has control over the partnership B by virtue of its majority stake;
- C’s control is imputed to A because C could exercise it rights and powers over the partnership either on behalf of A, or under A’s direction or for A’s benefit.
So it is clear that A and the partnership B are related where A has control over C. It is perhaps not so clear from the transfer pricing rules if A and C are fellow group companies, but with A not being directly above C in the group chain.
In the diagram, we see that V has indirect participation in the partnership through its holding in C, but A has no direct stake. How could one say that C’s rights and powers over the partnership be exercised on behalf of A, or under A’s direction or for A’s benefit? And yet A and C are clearly linked16.
Conclusion – it could have been a lot worse!
There have been so many rules restricting tax relief for IP in the last few years that one wonders what else the Government has up its sleeve. These new rules do however make sense in that old IP was always supposed to be transformed into new IP on a change in economic ownership, and that clearly isn’t the case with the partnership structure described in this article.
However, one should bear in mind the last time the IP rules were tweaked. While it made sense to restrict tax relief on goodwill acquisitions when seller and buyer were linked, it didn’t really make that much sense to do so on an outright sale to a third party – especially considering the original intention of the IP rules when they were first introduced.
Perhaps we should be thankful that the restrictions on tax relief on unrelated party transactions have gone no further than goodwill. But there is always the next Budget…
- CTA 2009 s 882. ↩
- CTA 2009 s 835. ↩
- See the case of HSP Financial Planning Ltd v Revenue & Customs (2011) UKFTT 106 TC which is discussed in another Tax Notes article. ↩
- CTA 2009 ss 1259, 1262. ↩
- CTA 2009 ss 1259(3), (4). ↩
- CTA 2009 s 816A. ↩
- CTA 2009 ss 1273(1), 1273(2)(c). Note that there are similar deeming provisions for all types of partnerships in TCGA 1992 ss 59, 59A. However, these provisions do not help as they deal with chargeable gains, whereas IP is taxed as a revenue item. ↩
- (2014) UKFTT 888 (TC). ↩
- New CTA 2009 ss 882(5A), (5D) applying TIOPA 2010 s 148. Inserted by FB 2016 Clause 29(2). ↩
- New CTA 2009 ss 845(4A) to 4(F), inserted by FB 2016 Clause 30(1). ↩
- See CTA 2009 s 850 (exclusion of rollover relief on part realisation involving related party acquisition); and CTA 2009 s 851 (delayed royalty payments made to a related party). ↩
- New CTA 2009 ss 882(5B), (5C); new CTA 2009 ss 845(4B), (4F). ↩
- TIOPA 2010 ss 157(2), 217(1); CTA 2010 s 1124(3). Note that there are other provisions where A may have less than 50%, but is still related by virtue of being one of a number of “major participants”. This is an instance of indirect control – see TIOPA 2010 s 160. ↩
- TIOPA 2010 ss 158 -162. ↩
- TIOPA 2010 ss 159(2), 159(3)(c), 159(4). ↩
- Normally we would say they are linked because A is connected to C. But for transfer pricing purposes, the question whether a person is connected does not actually involve companies, but individuals and trustees – see TIOPA 2010 ss 159(3)(d), 163. ↩
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