Originally, sale and leaseback transactions were applied to tangible assets, such as plant, machinery and equipment. However, since the mid–1990’s, its application has increasingly been extended to incorporeal property, including trademarks, patents, designs, copyright and know-how. When applied to intellectual property (IP), the “leaseback” and associated “rental payments” are more correctly referred to as “licence” and “royalties”, respectively.
On the face of it, intellectual property has the attributes that render it suitable for use in sale and leaseback transactions: intellectual property is an incorporeal/intangible – having no physical presence that may be required in the operations of the seller’s business; it typically has a high value – generally ranging between 25% and 80% of a company’s total asset value; and it is easily transferable – generally, transfer requires the conclusion of a written assignment, the recordal of the assignment on the relevant intellectual property register(s), together with delivery of the registration certificates.
A typical sale and leaseback transaction comprises:
- the sale of intellectual property by X to a Special Purpose Vehicle (Y) for R(capital);
- the grant of a licence in respect of the intellectual property by Y back to X for an initial period (typically between 5 and 10 years), the licence providing for minimum royalties totaling R(capital + interest), which mirror capital and (discounted) interest repayments that would have been payable on a loan for R(capital);
- the issuance of promissory notes (PNs) by X to Y “evidencing” payment of minimum royalties payable in terms of the licence;
- sale of the bare dominium (i.e. ownership rights less the right of use for the initial licence period) in the intellectual property by Y to Z (a person connected to X). Alternatively, Y could grant X an option to re-acquire the asset at the end of the initial licence period (this is typically done to enable Y to claim s11(gC) allowances for the acquisition of the intellectual property);
- cession of the rights in the licence agreement, absent of the rights to receive the minimum royalties for the initial period; and
- discounting the PNs by Y to a Bank for R(capital).
The benefits generated by the transaction include:
- (in some instances) Y claiming s11(gC) for the acquisition of intellectual property (excluding trademarks);
- the Bank including only (__R(capital + interest) – R(capital)__) into its gross income (treating the PNs as a s24J instrument or as trading stock), while X claims R(capital + interest) as royalty deductions, resulting in an arbitrage of R(capital), which is partly passed back to Y in the form of a discounted “notional interest rate”;
- should the PNs somehow find their way into the untaxed policy holders’ fund of the Bank’s sister Life Insurance Company, a further tax benefit of (__Rinterest__) will be enjoyed by the bank/insurance group. However, s23I was introduced into our Income Tax Act in 2009 to tackle this arbitrage.
Depending on the benefits sought, the transaction may have to be “tweaked” to circumvent the anti-avoidance provisions of s23D and s23G of our Income Tax Act. However, such actions are seldom divorced from additional tax risk.
You will appreciate that a sale and leaseback is akin to a loan – X receives R(capital) upfront and repays this together with (discounted) interest (in the form of minimum royalties) over the life of the loan (the initial period of the licence). But, whereas only the interest on a loan is deductible, a sale and leaseback “rolls” the interest up with the capital and results in X claiming deductions in respect of both, while the bank accrues the same income as it would have in terms of a loan (R(interest)).
Other “tax loops” could be added to a standard sale and leaseback transaction to increase its aggression and “tax efficiency”. For example, if:
- the intellectual property or the bare dominium therein is assigned to an entity in a tax haven (including Mauritius);
- the PNs are discounted to an entity in a tax haven (but see s23I);
- the “royalties” payments become the subject of credit default swaps (CDS’s) (but see s23I);
- the purchase price (R(capital)) is used by X to acquire derivatives from the Bank (which can be structured to ensure that the transaction results in no cash flow whatsoever – either at the beginning, during the term, or at the end of the transaction);
- the purchase price (R(capital)) is used by X in a s24I (forex) transaction; and/or
- the purchase price (R(capital)) is used by X to pay a “premium” in respect of a sinking fund policy, which is indirectly linked to the value of the trademarks, and which policy could even be “reinsured” by a cell captive in a tax haven,
significant (albeit not necessarily legitimate) additional tax benefits would result.
However, the mere fact that a sale and leaseback transaction looks like a loan is not sufficient to undermine its legitimacy from a tax perspective. This is clear from the following statement in Commissioner for Inland Revenue v Conhage (Pty) Ltd 1999 (61) SATC 391 (SCA) at p395:
“In the present case Tycon required capital to expand its business. Firstcorp was prepared to make the funds available. Both parties were aware of the tax benefits to be gained from sales and leasebacks and decided to follow that course.”
Due to the complexity of this type of transaction, to conclude an intellectual property sale and leaseback transaction requires expertise in the fields of tax, the law of contracts (in particular sale and licensing), intellectual property valuation and intellectual property law. Without the requisite expertise in any one of these fields, the parties may easily succumb to the pitfalls and hurdles placed in their way by our law. Our case law is particularly troublesome in that not only do various judgments contradict each other but the immature state of our law in this area encourages our Courts to look upon foreign law for inspiration in completing our legal canvass.
Accordingly, in the land of tax structures, intellectual property sale and leaseback transactions are the preserve of the risk-tolerant/immune. As long as a colourable commercial rationale is devised, the parties may well pass the line of defence drawn by our General Anti-Avoidance Rules (GAAR) (previously s103(1)), unhindered. However, a “transaction of appeasement” that artificially incorporates the specific interests and preferences of the seller (X), purchaser (Y) and advisor could well find a tough opponent in the doctrine of substance over form, which resorts to inter alia the following factors in a drive to remove the cloak of artificiality from the transaction and reveal the underlying loan:
- imperfect delivery of the intellectual property
- failure to record assignments of the intellectual property on the relevant intellectual property register(s)
- lack of intent on the part of Y to dispose, use and/or resell the intellectual property
- absence of proper acquisition and retention of the intellectual property by Y
- insufficient surrender by X of substantial control over the intellectual property, including control through an agent
- failure by the “owner” (Y or Z) to assume control over the intellectual property (i.e. assumption of the responsibility to instruct intellectual property attorney(s) in respect of the filing, prosecution and maintenance of the intellectual property)
- exclusivity of the licences rights granted to X
- failure to record the licence to X on the relevant intellectual property register(s)
- lack of freedom on the part of Y to exploit the intellectual property by licensing it to third parties – in this regard, one should not only have regard to terms in the contracts but also to the actions of the parties
- rights of the parties voluntarily to terminate the licence, which would have the consequent effect that any promissory notes for future payment of royalties are unenforceable as between X and Y (or any other party having knowledge of such conditions)
- reasonableness of the sales price for the intellectual property transferred by X to Y and by Y to Z
- the correlation between the sales price for the intellectual property and any amount required by X
- the calculation of the royalties and the quantum of minimum royalties payable by X
- comparability of minimum royalties and royalties used in the intellectual property valuation
- uncommercial renewal provisions following termination of the initial licence period
- interposition of a third party (Y) into the transaction without any commercial rationale (apart from reducing the taxable yield of the PNs as a 24J instrument)
- lack of negotiations between the parties
- absence of a proper due diligence by the purchasers (Y and Z)
- unfamiliarity of the parties with the import of the scheme and knowledge of the assets purchased by each purchaser (Y and Z)
- the close relationship between X and Z and the degree to which X exercises control over Z
- the lack of assumption of any risk by Y in the asset “sold”
- absence of proper authorisation for the sale of the intellectual property by Y to Z
- lack of consistency in terminology used in the contracts
Defeat at the hands of the doctrine of substance over form may taint the transaction with the brush of fraus legis, with the consequences that: the seller (X) is exposed to both interest and additional tax in terms of s89quat (interest) and s76 (200% penalty) of the Income Tax Act; and the advisor falls vulnerable to the criminal sanction of fraud and reporting actions in terms of s105A of the Income Tax Act. In such instances, the parties also have no ally in time, as disguised transactions are immunised against the normal 3-year prescription period in terms of s79 of the Income Tax Act.
Finally, despite the decision regarding the nature of royalties in the BP case (SCA), the principle relied upon in the court a quo (ITC11454) that royalty payments made to maintain and retain goodwill, market share, name, customers and reputation should properly be regarded as expenditure of a capital nature, could be relied upon by SARS – in my opinion, sale and leaseback transactions are most probably the only transactions that could trigger the application of this principle. If successful, the royalty payments by X would be regarded as capital in nature and therefore not deductible for tax. This result would render this transaction less attractive than a vanilla loan.
Accordingly, despite early success by the taxpayer in Conhage, which may have compelled Neville Chamberlain to wave the judgment and proclaim “peace in our time”, the questions still remain:
(a) intellectual property sale and leaseback transactions – tax avoidance or tax evasion?
(b) intellectual property sale and leaseback transactions – do they actually work?
Only time will tell … or does it depend on the facts?