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HMRC internal manual

Business Income Manual

Capital/revenue divide: intellectual property: transfer of know-how: in exchange for shares

In the case of John & E Sturge Ltd v Hessel [1975] 51TC183 the company, which carried on the trade of chemical manufacturers, had a secret process for the manufacture of citric acid by surface fermentation. Sturge exported its products to France, Holland and Belgium but was prevented from selling citric acid in Italy by a high tariff barrier.

In 1958 Sturge entered into negotiations with an Italian industrial group (‘the Montesi group’) to form an Italian company, which was to be owned jointly by Sturge and the Montesi group, for the exploitation of its secret process in Italy. During the negotiations it transpired that under Italian law dividends on the shares in the new company (‘Biacor’) could not be remitted to the UK unless Sturge subscribed for them in cash, and it was therefore decided that such shares should be issued in the first instance to a member of the Montesi group (‘Veneta Zuccheri’) and that Sturge should sell its ‘know-how’ to Biacor for a cash consideration which should be wholly applied in buying shares in Biacor from Veneta Zuccheri. Sturge was to end up, after subscribing further cash, with 40% of the share capital of Biacor.

On 28 July 1960 Sturge entered into five agreements with members of the Montesi group. By the first agreement it agreed to assign and sell to Biacor its secret processes and ‘know-how’ relating to industrial production of citric acid, and not to permit those processes to be otherwise used in Italy, France, Germany or Benelux, nor to export competing products to Italy, for a consideration of 410m lire, payable in instalments.

By the second agreement Sturge agreed to provide technical assistance to Biacor for 15 years in consideration of a royalty of 2% on sales of citric products.

By the third agreement Veneta Zuccheri agreed to sell, and Sturge agreed to purchase within two months of receiving each of the four instalments of the consideration under the first agreement, shares in Biacor of the face value of 50m lire, 50m lire, 75m lire and 175m lire respectively (350m lire in total).

In September and November 1960 chemists employed by the Montesi group visited the company’s plant and all its secret processes were disclosed to them.

The Court of Appeal decided that:

  1. the consideration for the disposal of the ‘know-how’ constituted a trading receipt since it was received otherwise than in association with the disposal of a capital asset,
  2. the consideration was a cash consideration since there was no contractual obligation on the company enforceable by Biacor to apply the cash remittances in acquiring the shares in Biacor,
  3. the effect of the first agreement, construed in the light of the second agreement, was that all the payments made by Biacor were earned by the company as and when they were receivable (and not in November 1960).

Russell LJ in the Court of Appeal explained that:

  1. the imparting of ‘know-how’ in itself is not to be regarded as the disposal of a capital asset, and
  2. the restrictions against selling citric acid in Italy and in respect of its production in certain other countries, which may have deprived Sturge of what might have otherwise become a capital asset, did not involve such a disposal, since a mere possibility cannot for this purpose be regarded as a capital asset.

On page 209 Russell LJ also explained that the acceptance of shares in exchange for trading stock and with a view to adding a new dimension to the profit making apparatus did not make receipt of those shares a capital matter:

`… if you have a small tobacconist with a fortuitous store of snuff in short supply, he may wish to enlarge his profit-earning base by exchanging that snuff for an issue of shares in a company owning a number of tobacconist’s shops, but, as was accepted, those shares would not be capital receipts in the hands of the tobacconist. They are not made such by saying that the tobacconist intended thereby and succeeded thereby in adding a new dimension to his profit-making apparatus. The question in that case would be not why something was done, but (as Mr. Potter [Revenue Counsel] said) what was done. If the object and effect of that transaction was the broadening of the profit-earning base of the trader and would not affect the taxable nature of the receipt, I do not consider that the object and effect should be held to have a different consequence in the case of imparting “know-how” for a consideration.’

In Thomsons (Carron) Ltd v CIR [1976] 51TC506 the company, which carried on the trade of manufacturing caravans in Scotland, had since 1948 exported many of its products to Common Market countries, and had sold them through agents. High import tariffs caused Thomsons export trade to diminish and eventually to cease in the first half of 1963. Later that year Rosart-Thomson, a Belgian company, was set up by Thomsons in conjunction with two Belgian nationals who had a factory there and who wished to take advantage of Thomsons’ established reputation in that country. The main object of Rosart-Thomson, of which the two Belgians and Thomsons were shareholders, was to buy, sell and build caravans and similar vehicles principally built by Thomsons. At the outset and on one subsequent occasion Rosart-Thomson allotted some of its shares to Thomsons in consideration for:

  1. Thomsons supplying Rosart-Thomson with technical ‘know-how’ concerning all types of caravans constructed at its Scottish factory, and
  2. the exclusive right for Rosart-Thomson to sell products made by Thomsons or Rosart-Thomson in Belgium, Luxembourg or France.

The Court of Session held, that in entering into the transaction Thomsons had not parted with any of its goodwill (its own Belgian business having ceased prior to the transaction), but had retained both its goodwill and its ‘know-how’ for exploitation through its participation in Rosart-Thomson. The transaction was therefore on revenue rather than capital account.

On page 515, the Lord President (Emslie) emphasised that Thomsons’ trade in Belgium had already effectively ceased; they gave up nothing by entering the agreement with the Belgian brothers. Thompsons was more akin to British Dyestuff Corporation (Blackley) Ltd v CIR [1924] 12TC586 than it was to Wolf Electric Tools Ltd v Wilson [1968] 45TC326:

‘When the test of Bankes L.J. [see BIM35705] is applied to the transaction in this case in all the circumstances found by the Commissioners it is clear that the Company gave up none of its property in exchange for the shares. Wolf Electric Tools Ltd [see BIM35710] is to be distinguished in respect that the taxpayer company there effectively gave up its business in India as part of the consideration for the shares with which the case was concerned.’