An amount falls into a taxpayer’s gross income and is subject to tax if it is either received by or accrues to that taxpayer. However, where a contract is reciprocal, i.e. each party intends its performance to be conditional upon performance by the other, accrual is suspended pending performance. For example, in a lease the obligation to pay monthly rent is conditional upon the lessor performing his obligation to provide the lessee with peaceful undisturbed possession of the property. Consequently, accrual of each monthly rental is suspended until the end of the month.
It is generally assumed that a licence is analogous to a lease and that accrual of all royalty payments is similarly suspended. However, let’s question this assumption, having regard to a bare licence with the following terms only:
Licensor grants licensee an non-exclusive licence in respect of the intellectual property for a period of 5 years, in consideration for which licensee undertakes to pay royalties in the amount of R1 million per year.
(The licence does not require the licensor to enforce the intellectual property against infringers, or to provide the licensee with technical services.)
First, let’s analyse the nature of a licence: a licence has been likened to an indemnity against patent infringement. If correct, a licence can be distinguished from a lease: in a lease, the lessor is required to perform all acts necessary to provide the lessee with peaceful undisturbed possession of the property; whereas in terms of a bare licence, the licensor merely undertakes not to institute infringement proceedings against the licensee. Referring back to the definition of a reciprocal contract, since “performance” requires a positive act, it is arguable that the licensor is not required to “perform”. In fact, if the licence is an indemnity against infringement proceedings, the licensor actually undertakes to do the exact opposite of “perform”.
It is therefore arguable that the entire R5m will be included into the licensor’s gross income in year one.
Let’s compound the licensor’s problems by assuming that the licensee cancels the contract at the beginning of year 2, without damages. The licensor would find himself out of pocket, having received R1m in royalties and paid R1.45m in tax. In turn, the licensor would reclaim from SARS the excess tax paid, but repayment by SARS takes time.
A different but similar problem arises with royalty pre-payments. For example, let’s analyse a licence concluded on the following terms:
Licensor grants licensee a non-exclusive licence in respect of the intellectual property for a period of 10 years, in consideration for which licensee undertakes to pay royalties in the amount of R1 million per year. The first 5-years’ royalties being pre-paid on the date of signature. In addition, licensor undertakes to provide technical services to licensee in order to enable the licensee to use the intellectual property.
The obligation on the licensor to provide technical services arguably renders the contract reciprocal and eliminates the accrual problem discussed above. However, a similar problem now arises with the receipt of the R5m royalty pre-payment. Since this amount is received, it automatically falls into the gross income of the licensor and is taxed in year 1, leaving the licensor with R3.55m (i.e. R5m x (1–29%)). (for this purpose, we have assumed that s24C of the Income Tax Act does not apply). Now, as with our previous example, let’s assume that the licence is cancelled without damages at the beginning of year 2. The licensor is required to repay to the licensee R4m in royalty-prepayments, but only has R3.55m available!
For this reason, consider structuring royalty pre-payments as interest-free loans, against which the royalty payments are set-off as they become due and payable.