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Court of Appeal Rules That Gains From Disposal Of IP Rights Are Not Taxable






Recently, the Court of Appeal in Keysight Technologies Malaysia Sdn Bhd v Ketua Pengarah Hasil Dalam Negeri [2024] MLJU 1271 ruled that the gains from the disposal of marketing and manufacturing intellectual property rights were of a capital nature and thus, were not subject to income tax. This alert summarises the Court of Appeal’s decision in this case.

 

Background


The taxpayer, Keysight Technologies Malaysia Sdn Bhd, enjoyed pioneer incentive since 2000, where it enjoyed a 10- year tax exemption for the income earned from its manufacturing activities in microwave devices and test instruments.


As part of its manufacturing and marketing activities as a full-fledged manufacturer, the taxpayer developed its own technical know-how. In 2008, the taxpayer shifted from being a full-fledged manufacturer to a contract manufacturer for Agilent Technologies International s.a.r.l (ATIS). This transformation was formalised through the execution of a Manufacturing Services Agreement and the Intellectual Property (IP) Rights Transfer Agreement (collectively referred to as Agreements). Under these Agreements, the taxpayer transferred all beneficial rights to its technical know-how (IP Rights) to ATIS in exchange for RM 821,615,000.00.


Subsequent to a tax audit, the Inland Revenue Board (Revenue) issued an additional assessment with penalty amounting to RM 311 million against the taxpayer by subjecting the receipt from the disposal of the IP Rights to income tax under Section 4(f) of the Income Tax Act 1967 (ITA).


The taxpayer lodged an appeal to the Special Commissioners of Income Tax (SCIT) as its previous attemptto challenge the Revenue via the judicial review route was not successful.

 

Decisions Of The SCIT And High Court

 

Both the SCIT and High Court dismissed the taxpayer’s appeal, concluding that the gains from the disposal of the IP Rights to ATIS were taxable under Section 4(f). Their decisions were based on several reasons:


(a)    The badges of trade test, which was applied to distinguish between capital and income, was only applicable to cases involving acquisition of property or land and did not apply to cases involving a disposal of intellectual property rights. 

 

(b)    The receipt from the sale of the IP rights was income in nature as there was no “outright sale” of the IP rights because only beneficial rights to the IP rights were transferred.

 

(c)     There was no evidence of registration of legal title of the IP Rights in the name of ATIS, as the taxpayer was still using the IP Rights in the manufacturing of the same products after the sale.


(d)     There was no evidence that the IP Rights referred to in the Agreements were the same, as the receipt represented payment for the taxpayer’s loss of income, based on the valuation method used in the valuation report.


Appeal To The Court of Appeal

 

Being dissatisfied with the High Court’s decision, the taxpayer filed an appeal to the Court of Appeal.

 

(a) The Taxpayer’s Arguments


The taxpayer argued that the gains from the disposal were of a capital in nature. It was contended that the High Court and the SCIT incorrectly applied an irrelevant “outright sale” test instead of the badges of trade test to determine the nature of the receipt.


Applying the badges of trade test would have led to the conclusion that the IP Rights were capital assets. Additionally, the taxpayer emphasised that after transferring the beneficial rights to the IP Rights through a contract, they retained only a licensee’s rights and no longer owned them.


Lastly, the taxpayer asserted that the receipt from the disposal did not constitute “compensation” for the loss of income.


(b) The Revenue’s Arguments


The Revenue argued that the gains from the disposal of the IP Rights should be categorised as revenue income as firstly, there was no outright sale of IP Rights as claimed. They highlighted that the taxpayer retained significant control and usage rights over the IP.


Secondly, the Revenue claimed that the gains represented compensation for projected future income loss stemming from the taxpayer’s transition from a full-fledged manufacturer to a contract manufacturer.


The additional assessment was made under Section 4(f) of the ITA, the badges of trade test was deemed irrelevant since the gains did not fall under Section 4(a).

 

(c) Court of Appeal’s Decision 


The Court of Appeal reversed the High Court’s decision and held that the gains from the disposal of the IP Rights should be considered a capital receipt rather than taxable income under Section 4(f) for the following reasons:


Application of the badges of trade test

 

The court applied the badges of trade test and clarified that the gains from the sale were not income as the taxpayer was involved in manufacturing acvities and not in the business of selling the IP Rights. Hence, the sale was an incidental act and not the dominant purpose of the transaction.


Furthermore, the taxpayer was found to have held and developed the IP Rights for nine years and this one-off transaction showed no frequency of similar sales. The transaction was carried out as part of a corporate restructuring exercise to fit its new business model as a contract manufacturer rather than for profit-making purposes.


There were no special efforts such as advertisements, made to attract buyers and the IP rights were sold as-is without enhancements to increase their merchantability.


The badges of trade test confirmed that the gains were from the disposal of a capital asset making it a capital receipt and therefore, not subject to income tax.


No proof of outright sale of IP rights


The Court of Appeal found that the Revenue's argument that there was no proof of an outright sale of the IP rights failed upon examining the Agreements. The IP Transfer Agreement clearly demonstrated the taxpayer’s intention to transfer all beneficial rights in the IP Rights to ATIS. The technology, defined as protected or unprotected know-how, was transferred from the taxpayer to ATIS for a consideration. Subsequently, ATIS licensed the IP Rights back to the taxpayer solely for contract manufacturing services. The Agreements explicitly stated that ATIS became the owner and licensor of the IP Rights, while the taxpayer retained no rights except to use the same for its manufacturing activities as a licensee. This proved the sale of the IP Rights to ATIS.


Moreover, intellectual property laws state that legal title exists only for registrable IP, such as patents and trademarks. Technical know-how, due to its confidential nature, was not registrable under law and was protected by contract law and laws governing confidential information. The court agreed with the taxpayer’s contention that the IP Transfer Agreement was the contractual means to evidence and protect ATIS’s ownership of the IP Rights post-sale.

 

Receipt as compensation for loss of future income


The Court of Appeal held that the “no outright sale” argument contradicted the idea that the receipt was for loss of income. For compensation for loss of income to be valid, the taxpayer must have sold the IP Rights. Without such a sale, there would be no loss of income necessitating compensation, making the “outright sale” test unsuitable for distinguishing between capital and income receipts.


Further, the taxpayer, now only a licensee of the IP Rights was compensated on a cost-plus basis, reflecting its reduced role and risks. The SCIT and High Court failed to recognise this. The valuation report’s methodology was irrelevant in determining the nature of the receipt. The Revenue’s argument about the gains being a compensation for loss of income was an afterthought, as they had assessed the gains as income even before reviewing the valuation report.


The Appellant’s continued use of IP rights


The argument that there was no outright sale of the IP Rights was undermined by the fact that the taxpayer continued to use the IP Rights under a license after the sale. Both the SCIT and High Court overlooked this crucial detail, which clearly indicated that the taxpayer no longer retained ownership of the IP Rights.


Before 1 March 2008, the taxpayer operated as a full-fledged manufacturer, making its own commercial decisions, owning the IP Rights and assuming all associated risks. After the conversion, the taxpayer was merely a licensee of the IP Rights with no ownership, and functioned as a contract manufacturer for ATIS. The inventory and associated risks were now borne by ATIS. Thus, the claim that there was no outright sale because the taxpayer continued using the IP Rights was unfounded.


No invocation of anti tax avoidance provision


The Court of Appeal found that the Revenue’s argument regarding the absence of an “outright sale” was further weakened by the fact that the Revenue did not invoke the anti-avoidance provisions under Sections 140 or 140A of the ITA to allege tax avoidance by the taxpayer.


The Revenue adopted inconsistent positions by contending, on one hand, that the receipt from the sale of IP Rights was income rather than capital, while on the other hand, arguing that there was no outright sale. Conversely, the Appellant logically argued that to receive a gain, it must have sold the IP Rights.


Hence, without invoking Sections 140 or 140A, the Revenue lacked a basis to claim there was no actual sale or that the receipts were income in nature.



Conclusion

 

In conclusion, the Court of Appeal’s decision underscores the distinction between capital and revenue receipts, emphasising the incidental nature of the IP Rights sale by the taxpayer. By applying the badges of trade test, the court clarified that the gains were capital in nature and thus, were not taxable under Section 4(f). This case highlights the necessity for clear tax treatment of intangible assets and the importance of proper classification in corporate restructuring transactions.


11 July 2024

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