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HMRC internal manual

Business Income Manual

Capital/revenue divide: intellectual property: transfer of know-how: to overseas companies

The treatment of sums received for allowing other concerns to use the taxpayer’s intellectual property depends on the precise circumstances of the transaction. See also BIM35501 for the Corporation Tax intangible fixed assets legislation, which may require the accounting entries in respect of know-how to be followed in computations of income for Corporation Tax, even if those entries are of a capital nature.

In the case of Jeffrey v Rolls-Royce Ltd [1962] 40TC443 sums received under agreements entered into with companies etc. in a number of countries for the sale of ‘know-how’ relating to aero-engine manufacture were held to be trading receipts.

During the manufacture of aero-engines Rolls-Royce had engaged in metallurgical research and the development of engineering techniques and acquired a fund of technical knowledge commonly called ‘know-how’. During the period 1946 to 1953 Rolls-Royce entered into a number of agreements with foreign governments and companies under which it agreed to supply information necessary to construct certain engines which it had developed and to license the other party to manufacture these engines. For example, by an agreement with the Republic of China the company undertook to license the Chinese to manufacture a Rolls-Royce jet aero-engine and to supply the necessary information and drawings; to advise them from time to time as to improvements and modifications in manufacture and design; to instruct Chinese personnel in their works and to release one or two members of their own staff to assist in China with the manufacture of the engine in consideration of the payment of ‘a capital sum of fifty thousand pounds’ plus royalties. Agreements in similar terms were entered into with the governments of Argentina, Belgium and Australia and companies in France, the United States and Italy. Some of these agreements provided for payment of an annual technical liaison fee in addition to the ’capital’ sum.

Rolls-Royce contended that the sums received related to the sale of a capital asset and were not trading receipts. The Revenue contended that the sums received under the agreements were normal receipts of a revenue nature of the trade or business carried on by Rolls-Royce.

On page 492 Lord Reid explained why the money that Rolls-Royce received was taxable income. Rolls-Royce had not disposed of any capital asset; the company retained all of the rights and knowledge in undiminished form. What Rolls-Royce had done was to exploit its capital assets by granting licences and teaching the licensees how to make use of them:

‘I cannot accept the contention that by each of these agreements the company sold a part of that capital asset and received a price for it. There is nothing in the case to indicate that that capital asset was in any way diminished by carrying out these agreements. The whole of its knowledge and experience remained available to the company for manufacturing and further research and development, and there is nothing to show that its value was in any way diminished. The company had not even given up a market which had been open to it. It could not sell its engines in these countries whether it made these agreements or not. If it had not made these agreements, it would have got nothing from these countries; by making them it was able to exploit its capital asset by receiving large sums for its use there. In essence, what it did was to teach the “licensees” how to make use of the “licences” which it granted.’

Lord Reid also considered it important that Rolls-Royce had made a policy decision to exploit its assets in this way and had entered into a series of such transactions. Finally Lord Reid dismissed Rolls-Royce’s claim that these transactions were not a part of its trade of aero-engine and motor car manufacture:

‘…the facts of this case clearly indicate that this course of granting “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 its technical knowledge, experience and ability. The company sought to rely on the fact that in the assessments appealed against its trade is described as “manufacturers of motor cars and aero engines”, but I see no reason why there should have to be set out a full description of the taxpayer’s trade, and this abbreviated description in no way misled the company.’

You should note that Upjohn LJ distinguished Rolls-Royce from Evans Medical Supplies Ltd v Moriarty [1957] 37TC540 (see BIM35705) because (starting at the foot of page 486):

  1. The nature of the ‘know-how’ in the two cases was different: ’In the Evans Medical case, the “know-how …[was] a basic necessity for the introduction of a successful pharmaceutical factory in Burma, and that very same ‘know-how’ would be applied in manufacture probably for a long time”, while the ‘know-how’ dealt with by Rolls-Royce bore a ‘quite different transient and changing character … more nearly akin to a trading asset’.
  2. (And this Upjohn LJ referred to as ‘the fundamental difference between the two cases’) the Evans Medical case was ‘isolated and special’, whereas Rolls-Royce, ‘as a deliberate matter of policy …[had] embarked upon a course of licensing others to manufacture its engines in countries where it was difficult or impossible to export engines of the company’s own manufacture.
  3. His Lordship found that in the Rolls-Royce case it was not possible to isolate the sum paid to secure ‘know-how’ from the consideration in respect of other benefits provided by Rolls-Royce.

Pearce LJ agreed with Upjohn LJ’s distinctions and added another. The payments in Rolls-Royce were for essentially transient knowledge whereas in Evans Medical there was a greater degree of permanence (at the head of page 486):

‘The knowledge sold in this case is not some secret of permanent value sold by an owner who is transferring or terminating his business. Such a sale would clearly be the sale of a fixed asset.’

Rolls-Royce did not give up any trade in the countries to which it transferred know-how whereas Evans Medical lost its Burmese trade.

In the case of Murray v Imperial Chemical Industries Ltd [1967] 44TC175 the UK company granted licences or sub-licences to seven overseas companies. ICI held an exclusive licence from Calico Printers Association Ltd to exploit throughout the world (except in the United States) the rights under a number of patents taken out by Calico Printers Association Ltd in respect of a process for manufacturing a man-made fibre. ICI was empowered at its discretion to grant sub-licences in respect of the patents to third parties, and itself took out a number of ancillary patents in respect of the same process.

ICI granted sub-licences in respect of the original, and licences in respect of the ancillary, patents to five western European and two Japanese companies. The agreements with the European companies provided, inter alia, for royalties on the basis of sales, etc., and for ICI to give the licensees technical assistance without any separately expressed consideration. They also contained a covenant by ICI, for itself and Calico Printers Association Ltd, in consideration of lump sums payable in instalments, that for a stated period neither ICI nor Calico Printers Association Ltd would manufacture or sell, or aid any third party to manufacture or sell, in the licensees’ territory, products (whether made under the patents or not) of a character similar to those made under the patents. The agreement with the Japanese companies was on similar lines but in terms such that the lump sum payable thereunder was found to be payable half for technical assistance and half for a covenant against competition.

The Court of Appeal found that the covenants against competition, being ancillary to patent licences granted for the term of the respective patents, were part and parcel of transactions which, taken as a whole, constituted dispositions by ICI of part of its fixed capital and so the lump sums received were not income.

In the case of Wolf Electric Tools Ltd v Wilson [1968] 45TC326 a UK company disclosed certain ‘know-how’ to an associated foreign company in return for shares in it. The issue was whether the value of shares was capital or income.

Wolf carried on business as mechanical and electrical engineers. In particular, it manufactured electric power tools, in which it had an extensive export trade. About 1950 its sole agency in India was taken over by Rallis India Ltd, an Indian company, which bought from the company on a principal to principal basis. In 1954, when the company’s exports to India represented over 10% of its total exports, Rallis India Ltd informed the company that, because of the Indian government’s policy of encouraging the setting up of local factories for making tools, the whole market would be lost unless Wolf undertook to manufacture tools in India. Preliminary arrangements to that end were made in 1956, and in 1958 Ralliwolf Private Ltd was incorporated in India to carry on Wolf’s trade in tools selected for manufacture there; the government of India consented to the formation of Ralliwolf Private Ltd on condition that Rallis India Ltd took a majority shareholding, which in the event was 55%. In 1959 Wolf subscribed for the remaining 45% (9,000 Rs. 100 shares) of the issued capital of Ralliwolf Private Ltd, in consideration, as to 5,375 shares, for the transfer of plant and equipment for the Indian factory, and as to 3,625 shares, for the supply of drawings, designs, technical knowledge, etc. Wolf also agreed with Ralliwolf Private Ltd to ‘keep out’ of India and Nepal, as regards the selected tools, for ten years.

Wolf contended that the information in question was a capital asset of its trade and that its disclosure was an investment operation; alternatively, that the shares were received as consideration for the ‘keep-out’ agreement. The Revenue contended that the transaction was a method of increasing Wolf’s income as mechanical and electrical engineers by using know-how to the best advantage in a market which might otherwise be closed, and that the ‘keep-out’ agreement amounted, not to an outright sale, but merely to an assignment for ten years in respect of the selected tools only.

On page 340 Pennycuick J in the High Court took the view that the effect of the entire transaction was simply to alter Wolf’s capital profit-making structure. So that, instead of having its own goodwill in India as regards the selected tools, Wolf acquired a 45% interest in Ralliwolf Private Ltd and from then on derived its profit through those shares:

‘In a case such as the present, the effect of the whole arrangement - and I must look at the whole arrangement - is that the trader receives a new capital asset, namely, the shares in the foreign company, in exchange for that which he previously had, namely, his connection or goodwill in the foreign country. That is a transaction of a wholly capital nature.’

The transaction was on capital account and the money received was not taxable income.