[2010] UKFTT 419 (TC)

TC00689

Appealsnumbers SC/3096/2008 & SC/3097/2008

Payment of licence fees by company – whether income of inventor or a third party – whether trading income of inventor (yes) – whether employment income of inventor (no) – whether annual payments (no) – whether assessments defective or invalid (no)

FIRST-TIER TRIBUNAL

TAX

UKCO

First Appellant

Mr XX

Second Appellant

- and -

THE COMMISSIONERS FOR HER MAJESTY’S
REVENUE AND CUSTOMSRespondents

TRIBUNAL: Tribunal Judges Peter Kempster & David Demack

Sitting IN PRIVATE in Birmingham on 13-16 July 2009

The Taxpayers’ Representativefor both Appellants

Mr Adam Tolley of Counsel (instructed by the General Counsel and Solicitor to HM Revenue and Customs) for the Respondents

© CROWN COPYRIGHT 2010

1

DECISION

  1. The hearing of these appeals was held in private and this Decision Notice has been anonymisedfor publication.

Introduction

  1. This case concerns appeals against a number of assessments, determinations and decisions in respect of income tax and national insurance contributions (“NIC”) for a number of tax years issued to the two taxpayers: UKCO and Mr XX (together, “the Taxpayers”). The appeals were heard together and in private pursuant to earlier case management directions.
  2. UKCO produces and sells a speciality product. It has a single customer: the US Government Department of Defence. In its corporation tax returns for the four accounting years ended 31 October 1999, 2000, 2001, and 2002 UKCO claimed a deduction for payments of licence fees (“the Licence Fees”). The Respondents (“HMRC”) contend that the corresponding receipt of the Licence Fees gives rise to UK tax liabilities and have issued assessments, determinations and decisions to the Taxpayers on a number of alternative bases of charge.

The assessments

  1. The assessments, determinations and HMRC decisions under appeal are as follows.
  2. Assessments raised on UKCO under paragraph 4(2) of Schedule 16 to the Income and Corporation Taxes Act 1988 (“ICTA”) covering the period from 1 November 1999 to 31 October 2002 (“the Para 4 Assessments”). In outline, a UK resident company is required to deduct at source basic rate income tax from certain “annual payments” and HMRC contend that the Licence Fees were such annual payments.
  3. Assessments raised on Mr XX under section 29 of the Taxes Management Act 1970 (“TMA”) for the tax years 1999-2000 and 2000-01 (“the Schedule D Assessments”). In outline, HMRC contend that the Licence Fees were the trading income of Mr XX.
  4. Determinations made in respect of UKCO under regulation 80 of the Income Tax (Pay as you Earn) Regulations 2003 for the tax years 1999-2000 and 2000-01 (“the PAYE Assessments”). In outline, HMRC contend that the Licence Fees were employment income of Mr XXso thatUKCO had a liability to deduct PAYE at source.
  5. Decisions in respect of primary and secondary Class 1 NICs due from UKCO for the tax years 1999-2000 and 2000-01 pursuant to paragraph 10 of schedule 4 to the Social Security (Contributions) Regulations 2001 (“the NIC Assessments”). In outline, these supplement the PAYE Assessments and assess the NICs that HMRC contend are due from UKCOif the Licence Fees were employment income of Mr XX.

The appeals

  1. HMRC accepted that valid appeals had been made by the Taxpayers against all the assessments, determinations and decisions(which for brevity we shall call “assessments”)described above.
  2. The Taxpayers’ grounds of appeal included a number of challenges to the validity of the assessments, as well as arguments on the bases of assessment.

The hearing

  1. The Tribunal took evidence as follows. For the Taxpayers: Mr XX adopted two witness statements dated 28 September 2008 and 16 December 2008, and gave sworn oral evidence; and Mrs XX adopted three witness statements dated 24 September 2008 and 16 December 2008 (two), and gave sworn oral evidence. For HMRC: Mr Neil Meylan (an HMRC officer in the Special Civil Investigations Office) adopted a witness statement dated 30 October 2008 and gave sworn oral evidence.

The facts

  1. The parties did not present an agreed statement of facts. Where there was a contested issue we make a finding of fact as recorded below.

December 1997 – The Licence Agreement

  1. In the mid-1990’s Mr XX invented an ingenious product called the {Invention}.
  2. Mr XX and Mrs XX were the directors (and Mr XX was the managing director) of a company which on 2 December 1997 changed its name to UKCO. Mrs XX was the sole shareholder of UKCO. Mr XX was managing director of UKCO until July 2001. Mrs XXexplained her understanding that she owned UKCO entirely and Mr XX owned the Invention product entirely.
  3. On 12 December 1997 Mr XX and UKCO entered into a written agreement (“the Licence Agreement”), drafted by Mr XXwithout any legal advice. Mr XX executed the Licence Agreement personally under hand and the company seal of UKCO was affixed with Mrs XX signing as director and company secretary of UKCO, and there was a witness signature. The Licence Agreement included the following provisions (there was no clause numbering):

It is hereby accepted by [UKCO] that [Mr XX] is the inventor of all products hereinafter known as {Invention} and is the beneficial owner of all intellectual property rights, future rights, trade marks, design copyrights and other valuable assets of the said products and that [Mr XX] has complete autonomy and authority to use those intellectual property rights in any manner whatsoever.

It is now therefore agreed that [Mr XX] do hereby join with [UKCO] in a mutually binding licence agreement for the transfer of all such intellectual property rights in the products known as {Invention} from [Mr XX] to [UKCO] for a pre-determined fixed period, under licence, so that [UKCO] can commence the establishment of a manufacturing, sales and marketing business for the sale of {Invention}, material handling equipment and other related items within that industry.

The territory to this agreement shall encompass all world market areas where the above products can be sold and shall not be solely restricted to the United Kingdom. However, any further assignments of interests in the {Invention} to any third party company will only take place by express agreement and by the assignment rights being conferred by [Mr XX] to that third party.

It is further agreed that [UKCO] will be responsible for the manufacture, development and distribution of such {Invention}, material handling equipment and other related items under the {Invention} name and that [UKCO] will also be responsible for the application of Patent protection, trademark protection and design copyright protection of all items, seeking UK, USA and other world-wide protection, that may be deemed necessary so that the long term interests of [Mr XX’s] inventions are adequately protected.

It is further recognised, that in the negotiations forthcoming with the US Government for the contractual sale of {Invention} products to US Government establishments, a corporate entity will be necessary in order to be able to negotiate and obtain such contracts, and that for obvious commercial reasons patent, trademark and design protection will be needed to protect the interests of [UKCO] and by implication [Mr XX] from any infringement of their rights. It is expressly agreed by [UKCO] that [Mr XX] is to be recognised as the inventor of such products and will be so named as such in any {Invention} patent applications, trademark protection and design copyright actions so that his long term rights as the inventor may not be prejudiced, whatsoever.

It is also agreed by [UKCO] that should it become necessary for a US company to be incorporated in order to comply with US Government requirements for contractual supply of {Invention} products to US Government establishments in the US, then this incorporation will be a decision at the sole discretion and agreement of [Mr XX]. Furthermore should this new company be charged with the sales and marketing of {Invention} products world-wide then the further transfer or assignments of any such aforementioned rights to the {Invention} programme is at the authority of [Mr XX] and is not that of [UKCO]. [UKCO] will only operate under the strictest compliance to the terms of this licence agreement and by agreement with [Mr XX].

The consideration was £1 paid and acknowledged on signature, plus:

On all sales generated by [UKCO] of {Invention} products ad other material handling related items [Mr XX] will receive licence fees from[UKCO] as remuneration for the use of his intellectual property rights over the licence period. The fees will be calculated as the sum total of 20% (twenty per cent) on the FOB values of each and every invoice raised and paid to [Mr XX] upon monies being received from the buyers. Such payments to be made to [Mr XX] in the currency of invoice used by [UKCO] and these payments are to be made directly to [Mr XX], or to his assigns, or as he so wishes and/or directs [UKCO] to so do.

It is agreed that payments to [Mr XX] under this licence agreement will commence 18 calendar months from the date of this agreement (ie June 1999). This grace period of non-payment is to allow [UKCO] the opportunity to develop the{Invention} product range, and to recover partial development costs prior to the licence fees commencing. Such information, relating to aforementioned sales to be maintained on file, and to be made fully available to [Mr XX] at all times and offered to him periodically by way of copy invoices.

This licence agreement granted to [UKCO] by [Mr XX] shall remain in force and be effective for a period of 60 (sixty) calendar months and will expire on the 11th day of December 2002. At that time all rights, whatsoever, to the sales, marketing, production or other uses, all patent rights, trade marks and design copyrights of the {Invention} will revert back totally to [Mr XX].

In compliance with the above, [UKCO] agree that upon the formal signatures being affixed to this agreement [UKCO] will execute a separate assignment document, which will transfer back to [Mr XX] all rights so transferred under this agreement to [UKCO] by [Mr XX]. Such a transfer will occur at midnight December 11th 2002 and in accordance with the termination of this licence agreement.

[UKCO] will have no automatic right to a licence renewal agreement and this contract is executed by [Mr XX] on that clear understanding.

It is further agreed, thatupon the formal signatures being affixed to this agreement, [Mr XX] will also execute a separate assignment document relating to the transfer of rights as detailed in the agreement and for the period so specified. Such assignment to be used for any future application of approvals so being sought.

December 1997 to December 1998 – Registration of the IP rights

  1. On 24 December 1997 an application for the trade marks {Invention names} was filed with The Patent Office by a firm of patent attorneys naming the applicant as UKCO. On 31 December 1998 the same firm of patent attorneys filed with The Patent Office a “Statement of inventorship and of right to grant of a patent” which (a) named the inventor as Mr XX; (b) named the applicant as UKCO; and (c) in the space marked “State how the applicant derived the right from the inventor to be granted a patent” stated “By virtue of employment of the inventor by the applicant company”.
  2. Mr Tolley for HMRC submitted that the applications were wrong and misleading, given the provisions in the Licence Agreement confirming that all intellectual property (“IP”) rights remained with Mr XX.
  3. In his testimony Mr XX stated that the basic intention was to generate credibility for UKCO by showing the invention as registered in its name. Suppliers were being expected to enter into substantial contracts with a company with few assets and being able to show the IP rights registered in the name of UKCO would give them confidence. Worldwide patent protection would be prohibitively expensive, so the {Invention} name was protected by trademark – that was considered sufficiently secure given that main customer was US Government. He was the managing director of the company and the reference to an employee was semantics.

March 1999 – Award of the GSA Contract

  1. On 11 March 1999 UKCO won a contract to supply {Invention} products to the US Government (“the GSA Contract”). It was a condition of the award of the GSA Contract that there should be a local (ie US) agent with a US bank account. That role was performed by a new Delaware company, formed in April 1999, “USCO”. Mr XX in his testimony explained that as well as the GSA Contract requirement for a US agent, it was convenient to use USCO because having a US company would enable funds to be paid and cleared faster.He was conscious of the “Buy American” legislation in the US – using a US company for production and sales was desirable. USCO was wholly owned by Mr YX (the son of Mr XX and Mrs XX); this was helpful in assisting him to obtain a US residency visa; the expectation was that USCO would be the main business vehicle in future. Both UKCO and USCO were family businesses with no outside investors; they were run informally with oral agreements. Mr XX was CEO of USCO.
  2. UKCO raised invoices and delivered these to the US Government. Payment was made by the US Government to USCO. USCO made three deductions from the monies it received from the US Government. First, USCO deducted and kept a marketing fee (of approximately 15% of sales). Secondly, USCO deducted the Licence Fees. Thirdly, USCO deducted the US Government levy and remitted this to the US authorities. After making those three deductions USCO remitted the balance to UKCO.

August 2000 – HMRC enquiry into 1999 accounts

  1. On 10 August 2000 HMRC opened an enquiry (under paragraph 24 of schedule 18 Finance Act 1998) into the tax return of UKCO for the year ended 31 October 1999.
  2. During the course of correspondence UKCO’s then adviser gave the following explanation of the licence fee deduction of £67,434.79 and the marketing fee deduction of £44,623.61 in a letter to HMRC dated 4 October 2000:

“A licence fee of 20% and a marketing fee of 15% of each sales invoice for “goods only” (that is not installation and freight) is payable to [USCO].

It is a requirement of [the GSA Contract] to maintain the services of an American corporation, located in the US, throughout the term of the contract “to assist and insure the Government of prompt and efficient contract administration” and “to assist in the resolution of any delivery, performance or quality complaints from customer agencies or to accept service of process in the event of any default by [UKCO] on behalf of the US Government.”

[USCO] complies with the above terms. It collects US government cheques and EFT payments on behalf of [UKCO] and deducts the invoiced amount of licence fees and marketing fees before remitting the balance due to [UKCO]. Its main function is to co-ordinate the marketing of the {Invention} programme for a US base dealing mainly with {XYZ International Inc}, an American marketing company employing 34 full time representatives who specialise in the US government sector. The marketing commission payable to {XYZ International Inc} on any business generated by them is 12% which leaves the balance of the 15% marketing fee to the US office [ie USCO] to cover running costs. This arrangement saves [UKCO] the cost of employing UK [which may be a mistype for “US”] representatives to market their products into a foreign marketplace.

No assets are required (or acquired) with respect to the marketing fee.

In December 1997 [UKCO] acquired a licence from the inventor [Mr XX] to produce patent pending {Invention} products until termination of the agreement in December 2002 in consideration of payment of a licence fee of 20% of the FOB sales value goods in the {Invention} programme.

Actual payment of the licence fee was agreed to commence from June 1999, after a start up period of grace. This licence fee amounting to £67,434.79 to 31/10/99 was assigned by [Mr XX] and collected by [USCO]. (Resources may be required in the US for future production and development of the American market in the event [the GSA Contract] is not renewed or if [UKCO] are unable to meet increasing demand to produce competitively in the UK.) As and when [Mr XX] receives income derived from assigned licence fees he will declare the same to the InlandRevenue.”

  1. Having received that explanation HMRC closed their enquiry into the 1999 tax return of UKCO on 19 October 2000, stating “No amendment is necessary to the company’s self-assessment.”

May 2001 – HMRC enquiry into 2000 accounts

  1. On 23 May 2001 HMRC opened an enquiry into the tax return of UKCO for the year ended 31 October 2000. The licence fee deduction for this year was £368,536 and the marketing fee was £464,844. On 19 June 2001 HMRC wrote to UKCO’s advisers:

“… I should like to see the agreements under which the fees, marketing fees and supplementary commissions are payable. I should also like to see please a copy of recent accounts for [USCO].”

  1. On 2 October 2001 there was a meeting between Mrs XX, UKCO’s adviser and an HMRC officer. The notes of that meeting – which were provided to and not challenged by Mrs XX or the adviser – state:

“It was eventually left that [adviser] would attempt to obtain the latest accounts from [USCO] and would also gather together the contracts between [UKCO] and [USCO]. Once he had these he would send them to [HMRC].”

  1. On 18 February 2002 HMRC issued to UKCO a formal notice requiring production of stated documents, including “copies of contracts under which all licence fees are paid by this company during the year ended 31 October 2000.” No documents were provided but on 19 April 2002 the adviser wrote to HMRC:

“The contract under which all licence fees were paid by [UKCO] during the year ended 31 October 2000 was a verbal contract.”

The copy of that letter provided to the Tribunal had been annotated by the HMRC officer:

“Telephoned [adviser] 22/5/2. He did not know that there were no written contracts until just before the date of this letter.”

  1. On 23 May 2002 HMRC wrote to the adviser:

“As there are no written contracts it seems to me that the only way forward will be for me to see copies of [USCO’s] accounts. As both [USCO] and [UKCO] are under the control of the same persons I would have thought the quickest way would be for [UKCO] to obtain copy of [USCO’s] accounts and send these on to me. However as your client refused to do this I am attempting to obtain copies of the relevant accounts through departmental procedures.”

  1. Those procedures involved the agreement for mutual exchange of information between HMRC and the US Internal Revenue Service. In January 2003 HMRC received from their US counterparts a copy of USCO’s US tax return for the year ended 6 April 2000; HMRC concluded that the turnover of USCO disclosed in its US tax return was significantly less than the deductions claimed by UKCO.

February 2003 – HMRC enquiry into 2001 accounts