This article will focus on income tax issues related to intellectual property (“IP”), including some of the tax implications of acquiring and disposing of IP rights.
First, we will discuss the implications of acquiring IP rights.
IP can be acquired in one of two ways: by creating and, where appropriate, securing IP rights (e.g. using a trademark in connection with goods/services or inventing and securing patent protection for technology), or by purchasing IP rights from a third party (e.g. through an assignment). In addition, the right to use (but not own) IP can be acquired by way of a license agreement with the IP owner.
Where IP rights are created (and secured where appropriate), different types of IP rights (i.e. trademark, patent, copyright, design, etc.) have different tax implications. For example, the cost associated with registering a trademark (including legal fees) are generally considered business expenses,1 which reduce a business’ profit for a taxation year and reduce the amount of tax payable in that year. In contrast, the costs associated with securing patent protection are generally considered to be capital expenses, which factor into determining the gain or loss only when the patent is ultimately disposed of. Tax deductions are generally not available in the year of purchase of capital assets.
Where IP rights are acquired from a third party, the cost of the acquisition is generally treated as a capital expense. Again, this means that no deductions are available in the year of the purchase. However, there are some exceptions to this rule. For example, a lump sum payment to acquire know-how or trade secrets will be considered a capital expense. However, if the know-how or trade secrets are acquired in an agreement with periodic (e.g. annual) payments, those payments are considered business expenses and are deductible in the year in which they are incurred.
Where IP rights are licensed from an IP owner, the licensee may be required to pay royalties (i.e. payments based on the profit earned by the licensee from use of the licensed IP) to the IP owner. For the licensee, royalty payments are considered business expenses, and are deductible in the year in which they are incurred. For the licensor (i.e. IP owner), royalties are considered business income, and are considered taxable income.
Disposing of IP
The tax consequences associated with disposing of (e.g. selling) IP generally depend on the “normal course of business” of the taxpayer. For example, where a taxpayer sells its IP portfolio to another party, the proceeds of the sale will generally be treated as a sale of capital property,2 meaning any gain will be half-taxable (or any loss will be half-deductible). However, if the taxpayer is in the business of buying and/or selling IP rights, then the proceeds will generally be treated as business income, which is fully taxable (or fully deductible in the case of a loss).
Similarly, where an author (e.g. a writer or an artist) of a work sells copyright interests in that work in connection with their profession as an author, then the proceeds of the sale will be taxable as business income. But, if the author sells a copyright portfolio outside the normal course of business, then the proceeds of that sale would generally be a capital receipt and gains would be half-taxable and losses half-deductible.
This article gives a brief introduction to the many complicated ways that IP rights can impact taxes. For more information, please contact a dedicated tax professional.
1 A taxpayer’s taxable income from a business in a taxation year is the profit (i.e. revenue minus expenses) earned from the business in that year. Business expenses reduce the amount of profit for a taxation year, and therefore reduce the amount of tax payable in that year.
Capital expenses are not deductible in the year the expense is incurred. Taxpayers must wait until the property is disposed of (i.e. sold) to determine their gain or loss.
2 Capital property is property which a business retains over time without the intention to sell (for example, a warehouse or storefront space). Gains from the sale of capital property are only half-taxable, while losses are only half-deductible.
For example, say a business purchases a warehouse in 2010 for $100,000, with the intention to use the warehouse indefinitely to hold its excess inventory. In 2015, the business sells the warehouse for $75,000. The business’ capital loss (the difference between the purchase price and the sale price) on the sale is $25,000. Therefore, the business’ “allowable capital loss” is $12,500 ($25,000/2). Thus, the business would be entitled to deduct $12,500 from its income for the 2015 taxation year. Note that allowable capital losses can only be deducted against capital gains; the Income Tax Act allows taxpayers to “carry” allowable capital losses forward or back to other taxation years if they don’t have any capital gains in the year the loss is incurred.