Canada: Canadian Tax Strategies For Managing Intellectual Property Assets

Originally published in The 2007/2008 Lexpert CCCA/ACCJE Corporate Counsel Directory and Yearbook

Strategic management of intellectual property assets can enhance the value of R&D programs by guiding business decisions and creating new opportunities for both savings and gains. The international harmonization of intellectual property law makes effective patent protection and IP management all the more critical to technology companies competing internationally.

We examine intellectual property (IP) management in the context of domestic tax planning and then explore a proposed tax planning model for a hypothetical Canadian company holding a portfolio of patents, copyrights and licences.

INTELLECTUAL PROPERTY MANAGEMENT

Companies can realize the financial and strategic value of IP in a number of ways, including acquiring an emerging new technology, entering a lucrative new market with a patent-protected product, strengthening their competitive weakness, blocking a competitor’s entry into key markets, increasing revenue from successful IP licensing and litigation, and implementing IP-based tax planning.

To pursue opportunities such as these, companies must develop an effective IP management program capable of analyzing the value inherent in individual patents and the IP portfolio as a whole. We propose that such a program begin with a focused patent evaluation process based on four primary criteria: (1) technology group, (2) patent lifetime, (3) use in industry, and (4) strengths and limitations. Each patent can then be classified into one of three value classes based on the four evaluation criteria. These value classes, and their corresponding patent strategies, form the basis for effective IP-based tax planning. The general nature of each value class is described below (a detailed process of patent portfolio review and value classification has been formulated but is beyond the scope of this article).

Class I Patents

Class I patents protect a company’s main product offerings and are therefore a company’s most valuable IP asset. They must remain well-protected by enforcement measures such as litigation, and should form the basis of core business strategies. The significant value of Class I patents is realized by protecting key products, restricting infringing activity and keeping competitors out of the market.

Class II Patents

Class II patents merit close attention in IP management practices because they offer the potential for increased licensing revenue, income on patent transfers, new business opportunities and substantial tax benefits. Any of the four evaluation criteria may account for the rating difference between a Class I and a Class II patent. For example, a Class II patent may in fact relate to the company’s core business, but the patent lifetime may be nearing an end or the claims of the invention may be written too narrowly. Alternatively, a Class II patent may be peripheral to the company’s core business, but may still have value based on its perceived use in other sectors, its potential application in emerging markets or filling a void in a non-competing technology platform. Patents assigned a secondary rating should undergo a more detailed internal review to characterize the value of core and non-core Class II patents. Core Class II patents should be maintained as perimeter protection for core technology and potential bargaining chips for cross-licensing. Non-core Class II patents should be considered for licensing and sale opportunities, as well as the revenue and tax advantages inherent in such transactions.

Class III Patents

Class III patents are those that are deemed to be of little or no value to the company’s business strategy. This determination may be based on a combination of criteria, including latent defects in the claims or specification, lack of demand for the technology, or an invention nearing the end of its 20-year term of protection. However, an "old" patent is not necessarily without value and it is therefore useful to compare the age of a patent with its current, and perhaps future, use in industry. The same consideration should be given to a "young" patent.

The evolution of patented technology generally follows a five-stage progression: (1) advanced technology, (2) ramping up, (3) state-of-the-art, (4) ramping down, and (5) abandoned technology. Ideally, technology progressing in this manner does so in step with the lifetime of a patent. Life-cycle management seeks to maximize the time in which a product can be commercialized while being protected by patents. Though the timing of life-cycle management varies among technology fields, the table below sets out a generally desirable life cycle.

If a technology or product appears to be progressing at this pace, any patents associated with it have an inherent value based on both patent lifetime and use-in-industry considerations. However, if the life cycle shifts at all, patent value may decline. For example, a patent that is 17 years old but still considered "advanced technology" may receive a Class III rating because of the limited commercialization potential of the three remaining years. This would represent a life-cycle shift to the right, where the advanced technology stage has shifted from years 1–3 to years 13–17. A life-cycle shift to the left may also warrant a Class III rating.

A patent that is only two years old and considered state-of-the-art may have significant prior art concerns. That is to say, if such a young patent is considered state-of-the-art technology, it is likely that it is entering a well-developed and highly patented field. A patent runs the heightened risk of being invalidated by evidence of prior art, which is a precarious situation in which to build a product. Finally, a Class III rating may be based on validity concerns, such as poorly written claims (too broad or too narrow), insufficiency of disclosure, obviousness or anticipation.

As discussed later, Class III patents offer strategic tax planning potential if they can be donated. Those that are flawed from a legal perspective should be abandoned, whereas those that are flawed from a commercial perspective should be donated.

DOMESTIC TAX PLANNING

In this section, we identify domestic tax advantages in relation to the patents and licences of a hypothetical Canadian technology company. Discussing the potential for SR&ED deductions or credits is beyond the scope of this article.

Eligible Capital Expenditures

IP assets are traditionally considered eligible capital property, which is defined in section 54 of the Income Tax Act (Act):1

A capital expenditure is a business expenditure that results in an enduring benefit made for the purpose of producing income. Expenses relating to the acquisition of eligible capital property are considered "eligible capital expenditures", as defined in subsection 14(5) of the Act. An eligible capital expenditure may be broadly described as an outlay or expense made or incurred by a taxpayer (a) in respect of a business; (b) as a result of a transaction occurring after 1971; (c) on account of capital; (d) for the purpose of gaining or producing income from the business; and (e) does not come within any of the capital cost allowance classes (or is not otherwise expressly excluded).²

Eligible capital property is generally regarded as intangible or "nothings", such as goodwill, trademarks or licences. For example, under eligible capital property provisions, where a taxpayer buys a trademark from another party who has developed an identity of enduring value, the amount paid for this intangible added value is an eligible capital expenditure (assuming that all the requirements of subsection 14(5) are met). In contrast, the costs of obtaining a trademark registration to protect a trade name, design or product are generally allowable as deductions in computing income.³ Eligible capital expenditures are allocated into a pool of "cumulative eligible capital" (CEC), as defined in subsection 14(5) of the Act. Very generally, three-quarters of eligible capital expenditures in respect of a business is added to the taxpayer’s CEC pool. Paragraph 20(1)(b) allows a deduction on the cumulative eligible capital amount at a rate not exceeding 7% at the end of each year.⁴

An outlay or expense made or incurred to acquire or in an attempt to acquire a patent, franchise or licence for use in a business may qualify as an eligible capital expenditure. However, to qualify as such, the intangible property must not fall within any of the capital cost allowance classes. A determination must be made regarding whether or not a particular intangible asset falls within a class of depreciable property. For example, if a company’s suite of licences-to-use or a company’s portfolio of patents are classified as depreciable property under Schedule II to the Regulations to the Act, capital cost allowance deductions supersede the paragraph 20(1)(b) CEC deductions.

Capital Cost Allowance

The term "capital cost" is not defined in the Act, though it generally means the full cost to the taxpayer of acquiring capital property for income-producing purposes. This includes not only the purchase price, but also legal, accounting, engineering and other fees incurred upon acquisition.⁵ Paragraph 20(1)(a) permits the deduction from income of such parts of the capital cost or such amounts in respect of the capital cost of property as is allowed by regulation. This is referred to as "capital cost allowance" (CCA). The CCA scheme is detailed in Regulation 1100(1), which stipulates the rate of CCA that may be deducted in respect of each class of depreciable property. The various classes of depreciable property are set out in Schedule II to the Regulations to the Act. Intangible properties that qualify as depreciable properties are described in Class 14 and Class 44. Class 14 assets are "property that is a patent, franchise, concession or licence for a limited period in respect of property," subject to certain exemptions. Class 44 assets are "property that is a patent, or a right to use patented information for a limited or unlimited period [emphases added]."

The difference between Class 14 and Class 44 patents is subtle, and is really only an election option by the taxpayer.⁶ A patent will be classified as a Class 14 property only if it has a "limited" lifetime. Class 44 does not have this restriction because patents (or the right to use patented information) in this class may have a "limited or unlimited" lifetime. This distinction is somewhat academic because the lifetime of a patent is always a limited period, as would be a licence to use a patent. Under the Agreement on Trade-Related Aspects of Intellectual Property,⁷ the term of protection in almost all WTO member countries is 20 years. Once a patent has been granted, its remaining lifetime can be determined at any point. Property that is a patent or a right to use patented information would thus naturally fall into Class 44, but a taxpayer may elect in the year of acquisition to classify such property as Class 14 property instead.

The CCA rate for Class 14 assets is generally straightline – that is, equal deductions over the life of the assets, whereas the Class 44 CCA rate is 25% on a declining balance basis. Since that latter rate allows for a relatively fast writeoff, it is usually advantageous to treat patents as Class 44 assets. In certain cases, this election option would also apply to licences that grant the "right to use patented information." For example, a licence to use another company’s patented product could be regarded as either Class 14 or Class 44 depreciable property. A licence related to the use of computer software would be added to (i) Classes 8, 10, 29, 39 or 40, or (ii) Class 12 depending on whether the computer software was "systems software" as defined in the Regulations.

Another option is available for patents in Class 14 or Class 44 whereby all or part of the cost of the patent depends on the use of the patent. In general, the taxpayer can choose to deduct the portion of the cost of the patent that is dependent on its use in the year such cost is incurred. Any portion of the cost of the patent that is not dependent on its use continues to be deductible on a straightline or declining-balance basis at the rate applicable to the relevant class. The total of the deduction based on (i) the use of the patent in the year and (ii) the CCA on the portion of the cost that does not depend on use is limited to the undepreciated capital cost (UCC) of the relevant class. This provides a full deduction for the cost of the use of the patent in the year such costs are incurred, as opposed to amortizing such costs on a straightline or declining balance basis.⁸

Royalties Paid on Computer Software

Historically, computer software has most commonly been protected by copyright rather than by patents. In 1988, the federal government amended the Copyright Act to include computer programs in the definition of "literary work".⁹ The significance of this legislation with regard to taxation has less to do with CCA on licences than with withholding tax on royalty payments made to non-residents of Canada in respect of certain intellectual property.

The Act requires a withholding tax of 25% on royalties paid by Canadian residents to non-residents of Canada "for the use of or for the right to use in Canada any property, invention, trade-name, patent, trade-mark, design or model, plan, secret formula, process or other thing whatever."¹⁰ It is noteworthy that a "royalty or similar payment on or in respect of a copyright in respect of the production or reproduction of any literary, dramatic, musical or artistic work" is exempt from withholding tax under the Act.¹¹ In Syspro Software Inc. v. R,¹² the Tax Court of Canada held that this exemption applies to the payments for the right to produce or reproduce software. However, since the exemption applies only to "production or reproduction", it clearly does not apply to payments made by end-users of computer software to non-residents.

Although the Act stipulates a 25% withholding tax rate on payments made by end-users of computer software, recent bilateral tax treaties that Canada has entered into have eliminated withholding tax on arm's-length payments to non-residents for the right to use computer software.¹³ Note that, for this purpose, the Canada Revenue Agency does not consider payments for downloaded software to be a royalty, but rather that the customer is making a payment to acquire the ownership of data transmitted in the form of a digital signal.¹⁴ Further, the right to use packaged or shrink-wrapped software is considered a sale of goods that is not subject to withholding tax.¹⁵

Despite the express provision in the Copyright Act for the protection of computer programs, it is worth remembering that in the context of both IP management strategy and IP-based tax planning, computer programs may in some situations be the proper subject matter of the Patent Act.¹⁶

In Re Application No. 096,284,¹⁷ the Canadian Patent Appeal Board ruled on a patent application for what was ostensibly a computer program. In the Board’s decision, computer programs were formally qualified as "algorithms", which were defined as "a set of rules or processes for solving a problem in a finite number of steps."¹⁸ The Board considered this definition to be within the scope of a "mere scientific principle or abstract theorem," which is excluded from patent protection under subsection 27(3) of the Patent Act. At a time when the computer industry was expanding, the Board may have envisioned future applications for software patents and established criteria to be applied by the Patent Office when considering such claims:

1. Claims to a computer programme per se are not patentable.
2. Claims to a new method of programming a computer are not patentable.
3. Claims to a computer programmed in a novel manner, expressed in any and all modes, where the novelty lies solely in the programme or algorithm, are not directed to patentable subject-matter under s. 2 of the Patent Act.
4. Claims to a computing apparatus programmed in a novel manner, where the patentable advance is in the apparatus itself, are patentable; and
5. Claims to a method or process carried out with a specific novel apparatus devised to implement a newly discovered idea are patentable.¹⁹

Points 4 and 5 in the list should be considered not only when drafting claims, but also when classifying for tax purposes the IP protection associated with a particular software product.

IP Management and Capital Cost Strategies

The CCA provisions and eligible capital expenditures discussed above should be applied to a company’s full portfolio of patents, copyright and licences. The CCA rates of Regulation 1100(1) are fairly generous, and the declining-balance method provides relatively high CCA deductions in the early years of an asset’s life, which reduces taxable income and taxes payable. The declining-balance method involves applying a uniform rate of depreciation to the undepreciated capital cost of the asset. For Class 44 patents, the rate applied is 25% on a declining-balance basis. Under this method of depreciation, the UCC of the asset never reaches zero, reflecting the reality that there is usually some value remaining at the end of the asset’s useful life.²⁰

As discussed earlier, Class I patents are a company’s most valuable intellectual asset and should be protected and maintained for the full 20-year term of protection. Class II patents represent an opportunity for revenue generation through licence or sale; however, they may not become attractive to other companies until the technology is considered to be in the ramping-up or state-of-the-art stage. For this reason, Class II patents should be maintained in the early years, applying the CCA against business income. If Class II patents are eventually transferred to another company, CCA deductions no longer apply, but savings in maintenance fees will reduce costs, and income from the sale or licence will add a new revenue stream to the business. For the purpose of estimating capital cost savings, the model projects that Class II transfers will occur after year 10 of the patent lifetime.

Class III patents should also be maintained for the first few years to benefit from the relatively large writeoffs that occur in the early years. Class III CCA should be set against business income for the first five years. If there is no sign of increasing value in these patents, they should be either abandoned or donated. Again, abandoning low-value patents may result in substantial savings in maintenance costs. Donation of patents to non-profit groups or universities offers further tax deductions on business income. Subsection 110.1(1) allows corporate deductions for charitable gifts. In general, the deduction for charitable gifts includes the total value of the eligible amount of gifts (calculated on fair market value principles or, in certain circumstances, calculated using the adjusted cost base of the property²¹) made in the year or in any of the five preceding years. Subsection 110.1(1) provides a list of entities that qualify as a eligible institutions for the purpose of corporate deductions on gifts, which includes registered charities, universities, municipalities, paragraph 149(l)(i) corporations and certain other organizations.

The potential benefit of well-managed CCA on IP assets is detailed below. For simplicity, it is assumed that the number of patents in the portfolio profiled below remains relatively constant, as new patents replace those that have reached the 20-year mark. It is also assumed that the number of Class I, Class II, and Class III patents remains relatively consistent. It is further assumed that no part of the cost of the patents is dependent upon the use of the patents. For simplicity, we have also ignored the half-year rule that limits CCA on Class 44 assets to 50% in respect of property acquired in the year or that became available for use in the year, and we have assumed too that there is no prorating for shortened taxation years.²²

A simplified example of a company’s CCA is provided in the table for patents added to Class 44 (25% CCA).

*This value is the total of Class I and Class II UCC, with the depreciated and donated Class III asset value being subtracted from Total UCC at the beginning of Y6. Assume that the value of the Class III asset was equal to $63,281 at the time of donation.

**This value is the total of Class I UCC only, with the depreciated and transferred Class II asset value being subtracted from Total UCC at the beginning of Y11. Assume that the value of the Class II asset was equal to $56,731 at the time of the transfer.

The initial capital costs of the company’s patent portfolio have been estimated at $400,000 for Class I; $800,000 for Class II; and $200,000 for Class III. The total UCC at the end of year 1 is $1.4 million. In this example, the patent holder has opted to treat each patent as a Class 44 property subject to a 25% CCA rate on a declining-balance basis. Consideration has not been given to the income from dispositions of patents.

The tax benefits of effective IP management are evident in the declining book value of the company’s patent portfolio. Each year, a significant CCA can be set against business income to substantially reduce taxable income and taxes payable. In a 20-year period, a patent portfolio having an original capital cost of $1.4 million can be written down to $399 (with appropriate transfers and donations). A total of $1,279,590 can be set against business income as Class 44 CCA. Before donation, Class III patents originally worth $200,000 provided $136,719 in CCA in the first five years.²³ Class II patents estimated at a cost of $800,000 provided a CCA of $743,269 over 10 years. Finally, while protecting the company’s primary technology, Class I patents worth an estimated $400,000 provided for a CCA of $399,468 over the 20-year lifetime of the patent. These financial benefits demonstrate why technology companies must focus first on domestic tax planning before developing an international tax planning program. Ignoring IP-based tax planning is clearly a competitive disadvantage for high tech companies.

IP management enhances a company’s competency in acquiring new technology, entering new markets, strengthening competitive weaknesses, increasing licensing and litigation revenue, protecting key markets and implementing IP-based tax planning. IP-based tax planning offers savings opportunities both domestically and internationally. With regard to domestic tax planning, capital cost allowance provisions or eligible capital expenditure provisions should be applied to a company’s full portfolio of patents, trademarks and licences.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.