§ (1) Where any company resident in the United Kingdom incurs expenditure for the purpose of its trade upon the acquisition of or the right to use know-how such expenditure is to be treated—
- (a) as an allowable deduction in computing the amount of profits or gains of that company's trade to be charged to corporation tax or provided the company so elects;
- (b) as expenditure eligible for relief under the provisions of Part X of the Income Tax Act 1952 where such expenditure is directly related to capital expenditure incurred subsequently by the company which qualifies for relief under the said Part X.
§ (2) In this section "know-how" means any non-patented data, special knowledge or skill, technique, process, formula, design, model or plan, or information concerning industrial or commercial experience related to the company's trade.—[Mr. Patrick Jenkin.]
§ Brought up, and read the First time.
§ Mr. Patrick Jenkin (Wanstead and Woodford)
I beg to move, That the Clause be read a Second time.
We are obviously nearing the end of our evening's work, and I am not surprised that the Government have decided that possibly it is time to call it a day. With their majority dwindling away, I can understand that they are reluctant to go on any longer.
The Clause is intended to expose and to remedy a curious anomaly, a product of the development of the case law dealing with the taxation treatment of "know-how" payments. If a company wants to 906 use a process, or to make a product, and it has not got a process to do it, it can either use its own research to discover one, or buy the process from somebody else.
I should make it clear that we are not talking about patents. Patents are entirely different, and the taxation treatment is governed by Statute. With a patent, by definition the information is available to the public, but protected by the patent laws, and the taxation treatment is quite clear. If one company takes a licence from another, and a running royalty is paid, that is treated as a revenue expense and receipt as the case may be. Before the Corporation Tax it was regarded as an annual payment, and tax was deducted at the source. Now, under the Corporation Tax, in the hands of a payer it is a trading expense, and in the hands of a recipient it is a taxable receipt.
Similarly, if there is a lump sum, the position is covered by Statute. Under the Income Tax Act of 1952 a lump sum paid for a patent is eligible for annual allowance and may be written off over the life of the patent. In the hands of the recipient, there is a slightly more artificial rule. He is entitled to spread the receipt over six years, which is a great advance on having to take it in as a taxable receipt over one year.
I mention the question of patents to contrast the position of "know-how" payments, because these are not governed 907 by Statute. A "know-how" payment is a payment for secret information of one sort or another, for information of special techniques of a wide variety, and I refer the Committee to subsection (2) which sets out the definition of "know-how" for the purpose of the Clause. It is almost a term of art. Taxation here is left to the general law and is based on the broad distinction between capital and income. If, in return for "know-how", a royalty is paid, it is regarded as income, both as a deduction from the payer and as a receipt for the recipient, though it may be regarded as an annual payment for tax purposes.
But the lump sum down payment for a grant of "know-how", brings this anomalous position, that most sums received for such a grant are regarded as taxable income, trading receipts, of the recipient, whereas the company which makes a lump sum payment for "know-how" rarely, if ever, can deduct it as a trading expense. The new Clause would give the trader the option of treating the demand as a deductible expense for that year or of following the patent pattern which entitles him to an annual allowance under Part X of the Income Tax Act of 1952.
The history of this curious anomaly is interesting. For many years, lump sum payments were regarded as capital in the hands of both the recipient and the payer and the Income Tax Acts were not applied. The Inland Revenue then began to argue, in a number of cases before the courts, that, if a company engaged substantially in research, and, as well as using the products of its research in manufacture, exploited its research by licensing products to other people, here or overseas, then this was to be regarded as part of its trade, and, notwithstanding the fact that a licence might be a lump sum to the company, this was as much a trading receipt as, for instance, the proceeds from the sale of its products and that it was irrelevant whether it came in a single payment or a running royalty.
The leading case on this is one about aero-engines, Rolls-Royce v. Jeffrey in 40 Tax Cases, page 443, in which Lord Radclyffe said:It seems to me that, so long as it kept its 'know-how' to itself, it used it for the manu- 908 facture of its own engines, and its value was expressed in the succesful sales which it achieved of those products … it is clear that it saw that, having the 'know-how', it could derive profit from the manufacture of its engines, even by others, in parts of the world where it either could not or would not sell or manufacture them itself, provided only that it equipped those others with the requisite expertise. So it turned the 'know-how' to account by undertaking, for reward, to impart it to the others in order to bring about this alternative form of manufacture.A number of cases since have consistently held, following that case, that, where there is a pattern of trading in the granting of licences for "know-how", this is to be regarded as part of the trading activity.
The only exception—I said that this did not apply in every case—is that of a company which disposes outright of a definite section of its business, in which case, although it can be called the grant of a licence for "know-how", it is, in fact, a disposal of the business. The leading case was the drug case in Burma, the Evans Medical supplies case, but this is very rare and difficult to establish and, particularly where there is a consistent pattern of licensing overseas, even though to grant the licence would wholly cut out the company from trading in that territory, this tends now, almost universally, to be regarded as a revenue receipt. It is a question of the course of conduct, the manner in which the company does business. In the great majority of cases, a payment for "know-how" is a revenue receipt.
I now turn to the payment in the hands of the payer, the licensor. Here, a line of cases establishes clearly that this is always regarded as a capital disbursement. Under the old rule laid down by Lord Cave in the Atherton case, it created an asset or advantage of enduring benefit to a trade. That was as long ago as 1926, and the law on this matter has stayed still since then.
For instance, evidence that the "know-how" may be a wasting asset, that someone else may catch up in a matter of years and achieve equality is irrelevant. No allowance can be made for tax. There can be no capital allowance and nor is it deductible as an expense. If one pays an annual royalty for "know-how", that is allowed, but if it is a lump sum, it is disallowed, with no account taken 909 of the course of conduct of the business concerned.
It is irrelevant whether a company may have made a series of lump sum payments for different pieces of "know-how": they are all regarded as capital disbursements and therefore do not come into account in computing the tax liability. I know of no case where, on the Rolls-Royce pattern, there has been a course of conduct of a business in which the Revenue have allowed a lump sum payment for "know-how" as a deduction.
It may be asked, "If there is this difference between the Revenue and the capital treatment of a consideration for 'know-how', why do not companies always insist on running royalties? Why do they accede to demands for a lump-sum payment?" The answer is that this does not rest with the paying company. The licensor may have something to say about it. Having spent a large sum on research, he is not prepared to let it go on the rather uncertain sales on which the royalty may be based. He wants to get something back in the kitty straight away.
Thus, the usual form of transaction is to demand a lump sum payment for part of the consideration and a royalty, calculated on the sales, in respect of the balance. The licensee is not in a position to dictate that he will pay only the royalty and he must pay a lump sum.
This is, without doubt, a trading expense in the ordinary commonsense meaning of those words. It is a necessary expense which is incurred in order to earn profits, and this is particularly important in the science-based industries, where the exchange of "know-how" and patented information is growing rapidly each year.
I have found it difficult to obtain figures, but I have tried to calculate what might be the cost of making this change in the law. There are some quite accurate figures of this country's overseas balance of licensed payments, but there seem to be few figures on the internal trade in "know-how" and patents. Expenditure under this head does not seem to be calclulated as a separate item. One can get some figures from an old F.B.I. Report, published in 1961, called "Industrial Research in Manufacturing Industry", and these suggest that the 910 total amount spent on the purchase of "know-how" by companies was about 3 per cent. of the total research expenditure incurred within those companies. If it was 3 per cent. in 1961, it might be 4 per cent. or 5 per cent. now.
More recent figures were given by a Board of Trade survey made in 1964 and published in the Board of Trade Journal of July, 1966, subsequently referred to in the recent publication Statistics of Science and Technology, published earlier this year. They showed that, on the balance of transactions, receipts for patents and "know-how" in this country totalled about £44 million, whereas expenditure overseas was about £41 million. On this trade we therefore have a credit balance of about £3 million. It could be suggested—and I admit that this is an extremely rough estimate—that the amount of internal trade in this respect might be about the same. However, as I said, this includes patents and running royalties for "know-how".
If one goes back to the 3 per cent. figure of the total internal expenditure on research, and links that with what that expenditure is in the current year—about £452 million—this suggests that the total amount spent for "know-how" is about £10 million to £12 million, but part of that will be in the form of running royalties and the figure will, therefore, be something less than that; perhaps between £5 million and £10 million. This might be the amount spent annually by companies in Britain on acquiring "know-how" in exchange for lump sum payments. On an assumption of tax at 40 per cent., that gives a total cost of about £4 million a year. I admit that this is a rough-and-ready calculation and I stand to be corrected if the Chief Secretary has more accurate figures.
Is this a necessary feature of trading? The answer is, "Emphatically yes". The National Institute published a commentary on the F.B.I. paper, which I quoted, in its issue of May, 1962, in which it was stated:… the evidence strongly suggests that licensing arrangements are almost always supplementary to the firm's internal research activity and only very rarely a substitute for it".The F.B.I. paper quoted a comment from a large chemical firm, which stated:We acquire manufacturing know-how from outside organisations when the information is 911 not available from our own research activities or when offered processes appear better than those available from internal sources. It is a good spur to research to have this competition from outside organisations. Licensing arrangements also allow greater concentration of internal effort on major areas. Licensing by us of some of our know-how to other companies helps to support adequate research in these licensed areas.This shows that this business of "know-how" is an adjunct to the technical effort that must be made if we are to keep abreast of our competitors.
It is idle to expect any country, let alone any firm, to be self-sufficient in this matter, and any country or firm which attempted to do so would soon find itself struggling to keep abreast of its competitors. The exchange of information—including secret information—is vital to the technological progress of the science-based industries.
This point is relevant to the need to grant tax allowances of the type we are discussing, for if the science-based industries—the innovating industries—are to continue to expand, develop and afford to do their own research, they must have the necessary profits out of which to do it.
An interesting paper entitled "Prices, Products and Innovations", read in February of this year by Dr. Gordon Fryers, a well-known figure in the pharmaceutical industry, contained this comment:Research spending must in the long term be linked to the returns from sales and the profit margins in prices. Thus prices, profits and competitive innovation are intimately linked.I believe that to be a very true statement. H goes on to say in the rest of the paper how our tax system appears almost to discriminate against the innovator as opposed to the traditional industry—what, in the pharmaceutical industry, is called the generic producer. He quotes Corporation Tax, high rates of personal tax on scientists, and so on.
If an innovating firm, in order to keep abreast of developments, has to buy some of its "know-how" and processes from other companies and has to spend part of that money in a lump-sum payment, it is allowed no tax deduction at all. It is quite a ridiculous anomaly. If the information is patented, it is covered, whether it is running royalty or lump-sum receipt. "Know-how" for running royalty is 912 covered, but if it is "know-how" in return for a lump sum payment that lump sum payment is not regarded as deductible for tax payment.
The new Clause would remedy that situation, and would be an overdue removal of a small but significant brake on industrial modernisation and technical innovation in what must be by any standards a vitally important sector of British industry. For that reason, I commend it to the Committee.
§ Mr. Diamond
Let me say straight away that I agree completely with the hon. Gentleman that this new development that we call by the rather vague term of "know-how", but which we all understand very well, is an essential part of developing technological advance, and that it is not the desire of the Government or of industry to put any bar in the way of development of this kind. For this country, particularly, it must be something that we are very interested in fostering.
The hon. Gentleman is quite right in saying that the law makes no express provision, either by Corporation Tax or Income Tax, as far as I am aware, for "know-how". But I was rather surprised to hear him describe the practice today, because my information is that by and large there is at present no great difficulty for the paying company, in terms of either paragraph (a) or (b) of his own new Clause; that is, either as revenue or capital expenditure ranking for capital allowances or grant. There would be no difficulty in most cases of such expenditure so ranking. The hon. Gentleman suggested that there were cases where a substantial payment is treated as capital expenditure which does not rank for any further relief at all.
I recognise that even if present practice covers the area very largely, this is a developing field and there are those who fear that new developments may not be covered satisfactorily—and, I repeat, the law does not expressly provide for this when perhaps it should. But this is a big topic and it is one on which I am not, I regret to say, able to offer a considered opinion at the moment. It deserves very careful consideration and, as the hon. Gentleman has pointed out, there is the problem not only of relieving the taxpayer but of looking after the 913 Revenue, too, in terms of clarifying the taxability of a receipt, either lump sum or current receipt, and preparing a satisfactory code.
I therefore suggest that, to give us full time to have the matter very fully considered, the hon. Member might be good enough not to press the Clause. The Clause, as he has put it forward, would not be wholly satisfactory. I do not quite know why he has limited it to companies. A partnership or an individual surely would be just as interested, and we would want to widen it in this way.
I hope that the hon. Gentleman feels that I understand the problem, and we will look at it in a very similar way in the way that he would look at it. I hope that he will feel that this is not a problem which we can satisfactorily deal with between now and Report—nothing like it. I hope that he will feel that it is an area where we would and should consult industry and the professions fully.
In these circumstances I hope that the hon. Gentleman will feel, if I give a very clear undertaking, as I now do, that we will have the whole of this field very carefully examined between now and next year—I could not indicate before that—and that we will consult in the way that we have indicated, that his speech has been very fruitful and useful, that he will accept our assurance that we are very grateful for it, and that he will take the view that there is no need at this time to press the Clause to a Division.
§ Mr. Patrick Jenkin
I am sure the whole Committee will have recognised that as a most helpful and forthcoming reply from the Chief Secretary. I entirely take his point that the Clause as drafted is limited to companies, but this is because it was thought that the vast majority of cases of "know-how" will emanate from companies, though patents may well emanate from individuals. The necessary techniques and expertise to develop saleable "know-how" are generally beyond the capacity of an individual, or even of a partnership. Clearly, the principle is exactly the same, and if the Government will look at this we shall have no objection whatever to their looking at it in the whole context.
As to the present treatment, I was most interested to hear what the Chief Secre- 914 tary had to say. Likewise, those who will have to deal with the situation in the intervening year will be most interested in his speech. I have made some inquiries about this, and I have been told of no case where a lump-sum down payment has been allowed as a deduction. The capital allowance provision is entirely statutory, so it could not be allowed as a capital allowance in the same way as a patent is, so it would not come within the relevant section of the Income Tax Act, 1962.
§ Mr. Diamond
It could be a lump sum payment related to a physical asset and therefore be added to the cost of the asset and rank in that way.
§ Mr. Jenkin
I recognise that companies will sometimes go to very great lengths to achieve just exactly that situation, because, if they set about it in a more straightforward way, they would be penalised. I entirely take the right hon. Gentleman's point on that.
Though we are, perhaps, a little disappointed that the Government cannot do anything about it this year, we recognise that this is a complicated, complex field and that clearly there must be full consultation before a Clause is written into our taxing statutes which would do justice both to the taxpayer and to the Revenue.
In these circumstances it would be wrong for me to advise my right hon. and hon. Friends to press the matter to a Division tonight. We shall look forward to seeing what the Government produce in next year's Finance Bill. In the meantime, I beg to ask leave to withdraw the Motion.
§ Motion and Clause, by leave, withdrawn.
§ Mr. Iain Macleod (Enfield, West)
I beg to move,That the Chairman do report Progress and ask leave to sit again.We have been accustomed to moving this Motion at a few minutes to Twelve o'clock, but there is no harm in lowering the average a little and trying it at the other end of a full day's work. There are only two debates left, of which one will be certainly short. The other, the charities debate, is an important debate, and if we started it now, we should run into trouble, particularly as it is Thursday night with Members representing Scottish constituencies wanting to catch 915 their trains, and with all the other complications which we know about in the House of Comomns. We can be quite confident now that we shall be able to complete the Committee stage of the Bill in, or even slightly less than, the half day which is set aside on Wednesday of next week. Rather than start the charities debate now, I suggest that the Government agree that we report Progress.
§ Mr. Diamond
I am most grateful to the right hon. Gentleman not only for what he said, which covers a certain matter most satisfactorily, but for the co-operation which he and his right hon. and hon. Friends have given throughout the day. I readily assent to his proposal.
§ Question put and agreed to.916
§ Committee report Progress; to sit again Tomorrow.