We now live in an increasingly knowledge-based world where ideas, concepts and unique people skills are often essential to a company's commercial success. Indeed, the valuation of many companies now heavily depends on their intellectual property (IP) assets, which can command a large premium on sale. In recent years, the UK's archaic tax laws have struggled to cope with the enormous growth in IP assets and new economy businesses. Historically, little or no tax relief was given for most types of intangible fixed assets (for example, commercial know-how, business formats, franchises, brands, logos, etc), even though they often underpinned the commercial viability of the business. Similarly, purchased goodwill was treated as a capital asset and did not attract any relief against trading profits. On the other hand, many foreign tax jurisdictions already granted tax relief on goodwill and IP, making it unattractive to hold such assets in the UK.

I will review the main aspects of the Finance Act 2002 (FA 2002) intangible fixed assets (IFAs) regime, which introduces radical changes to the tax treatment of IFAs. (All statutory references are to Sch 29, FA 2002, unless stated otherwise.) These new rules only apply for corporation tax purposes. In particular, they enable companies to enjoy tax relief on purchased goodwill and most forms of IP. The FA 2002 IFAs regime adopts the increasing legislative trend of following the accounting treatment, using generally accepted accounting principles (GAAP). Hence the tax relief on purchased goodwill and IP will usually be based on the amount amortised or written-off in the company's accounts.

Scope of the FA 2002 IFAs regime

It is vital to appreciate that the FA 2002 IFAs regime only applies to IFAs that are internally created, or acquired from a 'non-related' thirdparty, after 31 March 2002 (para 118(1)) – the legislation refers to these as 'chargeable intangible assets' (CIAs).

This means that (all other) IFAs held by the company on the 1 April 2002 commencement date or those acquired from a related party who held them on that date (termed 'existing assets') continue to be dealt with under the existing tax rules relevant to the particular IP assets. The grandfathering of existing assets means that they will generally remain within the corporate capital gains regime, subject to special rules for certain types of asset.

The related party rules prevent existing goodwill and other IFAs being 'refreshed' while under the same economic ownership so as to benefit from the new tax reliefs. This would mean, for example, that goodwill transferred on the incorporation of an existing business would retain its capital gains status in the hands of the company (see Panel 1). Similarly, tax relief on goodwill and IP assets cannot be generated by arranging for such assets to be acquired by a fellow member of a corporate group (see below)

The key effect of the commencement date rules is that the FA 2002 IFAs regime will only begin to apply on a gradual basis as companies begin to acquire IFAs on business acquisitions, etc, or create new IFAs. We will therefore have two regimes running together, with CIAs being taxed under the FA 2002 IFAs regime and existing assets normally remaining subject to capital gains treatment (without any time limit).

Certain types of IP assets are excluded from the new IFAs regime, such as research and development expenditure, which will often qualify for its own special tax breaks (para 82). By making an election under para 83, companies can elect to exclude computer software from the IFAs regime so that capital allowances can be claimed instead. This is likely to be particularly beneficial where 100% first year allowances are available.

Tax relief on purchase of IFAs

The timing of the tax relief for CIAs generally follows the rules set out in

FRS 10, Goodwill and Intangible Assets. It therefore becomes more important to appreciate how such assets will be dealt with in the company's accounts.

FRS 10 defines 'intangible assets' as non-financial fixed assets that:

• have no physical substance;
• can be separately identified (ie, they can be sold separately from the business); and
• can be controlled through legal rights (such as patents or custody of confidential data).

Intangible assets purchased separately (from a business) must be capitalised in the balance sheet at cost. Where such assets are acquired as part of a business, they should only be capitalised separately from goodwill where their value can be measured reliably on initial recognition.

Purchased goodwill represents the amount by which the cost of an acquired entity exceeds 'the aggregate of the fair values of that entity's identifiable assets and liabilities' and should also be capitalised.

FRS 10 requires goodwill and intangible assets to be amortised or written off against profits over their useful economic lives. There is a rebuttable presumption that the economic life of goodwill cannot exceed 20 years. If goodwill, etc, is amortised over a longer period, its value must be regularly tested for 'impairment' under FRS 11, Impairment of Fixed Assets and Goodwill. Any write-off of goodwill under an impairment review in accordance with FRS 11 would be allowable for tax purposes under the IFAs regime. (No tax relief is, however, available for goodwill arising on consolidation.)

Clearly, the accounting treatment adopted will influence the timing of the tax relief for the purchased goodwill or IP, etc, being based on the amount amortised in the accounts (paras 7 to 9). However, as an alternative, companies may elect to claim tax relief at the rate of 4% a year (straight-line basis) of the goodwill/IP cost (paras 10 and 11). Hence, this election would be beneficial where the goodwill, etc, is either not amortised or is amortised over a period exceeding 25 years.

The Inland Revenue has built in appropriate protection to adjust the tax values used where the accounts are not drawn up in accordance with GAAP. However, the Revenue recognises that the treatment adopted in any particular transaction will often depend on the exercise of accounting judgment, and it has indicated that inspectors will not use the accounting 'override' powers simply because they may have taken a different view.

Credits relating to CIAs

Where credits relating to CIAs are booked in the accounts, such as receipts from intangible assets, revaluations or negative goodwill attributable to CIAs (known as 'Part 3' credits), these will be taxed as income profits (paras 13 and 14).

Similarly, profits arising on the sale of goodwill and other intangible property credited to the profit and loss account under

FRS 3 (known as 'Part 4' credits) are also taxed as income rather than capital gains (paras 18 to 24). However, the tax charge on such realised profits (ie, Part 4 credits) may be deferred under the IFAs rollover relief regime. This enables realised profits to be deferred for tax purposes provided the related proceeds are reinvested in new CIAs within the reinvestment window, which starts one year before and ends three years after the gain occurs (or such longer period as the Revenue may allow) (paras 37 to 45). (Part 3 credits do not qualify for any deferral relief.) The IFAs rollover relief is modelled on the existing capital gains rules. Thus, to obtain full rollover relief (at least) the entire proceeds must be applied in acquiring new CIAs – ie, the gain is deemed to be reinvested last.

The IFAs rollover relief works by deferring the gain on a pound-for-pound basis once the qualifying reinvestment expenditure exceeds the original base cost of the old asset (or, for partial realisations, the pro rata base cost). The profit realised on the sale of the old asset reduces the tax base cost of the replacement CIA, and hence the amounts available for future tax deductions (see below).

Any rollover relief claim will therefore create a mismatch with the carrying cost of the new CIAs in the accounts. Separate computations would be necessary to calculate the tax deduction for each period and keep track of the post-rollover relief base cost applying for tax purposes. The allowable tax debit for the new replacement CIAs is reduced on a pro rata basis. In the period of acquisition, this would be calculated as follows:

Accounting write-off x Tax cost*

Accounting cost

*ie, original cost less gain rolled-over

The allowable tax debit for that period would reduce the tax base cost carried forward, and the restriction for subsequent periods would be calculated as follows:

Accounting write-off x Tax value*

Net carrying value in accounts

*as reduced by prior tax debits

Where a gain is rolled-over under the IFAs regime, the overall effect of the above formulae is to tax the rolled-over gain over the life of the replacement asset(s). Rollover relief is also available on a group-wide basis (between companies in a 75% group relationship).

IFAs rollover relief is extended under a special rule that enables income gains to be rolled-over against the underlying CIAs of an acquired company (provided that at least 75% of its share capital is purchased).

This special relief seeks to give some neutrality between asset- and share-based acquisitions. The broad effect is to look through the shareholding investment in the 75% subsidiary to its underlying CIAs (ie, intangible fixed assets) purchased under the IFAs regime. In such cases, the realised profits on IFAs are deducted against the carrying values of the relevant CIAs owned by the subsidiary at the time of acquisition (para 57).

Transitional CGT rollover relief issues

The FA 2002 contains some important rules that may restrict the availability of CGT rollover relief. From 1 April 2002, capital gains arising on the sale of existing goodwill cannot be rolledover under the capital gains rollover system in s152, TCGA 1992. Instead, such capital gains can only be deferred under the IFAs regime on new acquisitions of goodwill and intangible fixed assets.

The purchase of goodwill after 31 March 2002 ceases to be a qualifying business asset under the CGT rollover relief rules. For example, a capital gain arising on the sale of a factory in (say) June 2002 cannot be rolled-over against goodwill acquired in (say) December 2002. However, under the transitional rules, goodwill can be used in a capital gains rollover claim provided it was purchased before 1 April 2002 and within the requisite 12-month period before the factory was sold. Any disposal of goodwill before 1 April 2002 may be rolled-over under the capital gains regime in the normal way, ie, against trading property, fixed plant, etc (subject to the above restriction on post-31 March 2002 goodwill acquisitions).

Patent royalties

Historically, corporation tax relief has been claimed on patent royalty costs under the charge on income regime (ss74(1)(m) and 338(3)(a), ICTA 1988), and so they were only relieved as and when they were paid. Royalties payable (or receivable) are now dealt with under the FA 2002 IFAs regime, regardless of whether they relate to CIAs or existing assets (para 119). (Since 1 April 2001, companies have been able to pay patent royalties, etc, to other UK resident companies (or UK branches) without deducting income tax.)

From 1 April 2002, patent royalties are no longer deducted as a charge on income. Instead, they are relieved as a normal Sch D Case I deduction on an accruals basis (para 8). Broadly, for accounting periods ending after 31 March 2002, relief is given for the amount incurred (ie, charged) during the relevant period. As a transitional measure, any accrued royalties at 1 April 2002, which would have been deductible had the new accruals basis previously been in operation, are effectively deducted immediately after 1 April 2002 (para 119(3)) (see Panel 3).

Exceptionally, any royalty payable to a related party (who is not subject to UK corporation tax on the receipt) that remains unpaid more than 12 months after the accounting period end, can only be relieved when it is actually paid. This rule would typically apply to royalties payable to an overseas group member (para 94).

Group transactions

CIAs (ie, the new regime IFAs) can be transferred between group companies on a tax neutral basis under the Sch 29 regime (paras 55 and 139). For these purposes, the 'group' definition is based on 75% ownership of subsidiaries and is very closely modelled on the one used for capital gains purposes. The effect of the deemed tax neutral transfer rule is to deem the relevant CIAs to be transferred at their (adjusted) tax value to the transferor group company, irrespective of the actual consideration passing between the companies (and recorded in their accounts). It must be remembered that any intra-group transfer of existing capital gains regime assets is still covered by the no-gain/no-loss rule in s171, TCGA 1992. Such assets retain their 'existing asset' status in the transferee company's hands (as a related party acquisition of an IFA held by a group company on 1 April 2002).

A CIA degrouping charge arises where, following a tax neutral intra-group transfer, the transferee company leaves the group within six years (still holding the relevant CIA). This would involve a deemed realisation (and immediate reacquisition) of the asset at its market value, normally giving rise to an income profit for tax purposes (para 58). Various exemptions and reliefs (broadly similar to those available under the capital gains degrouping rules in s179, TCGA 1992) may apply to mitigate a CIA degrouping charge.

Corporate deals

The FA 2002 IFAs regime is one of the most important corporate tax developments for many years. The ability to obtain tax write-offs on goodwill and other intangible assets is bound to change the methodology of future corporate acquisitions and disposals. In addition, the interaction of this new regime with the exemption for disposals of substantial shareholdings (see Accountancy, November 2002, pp114-116) will also need to be considered. The tax impact on a deal involving material goodwill/IP is now likely to be fundamental.

Although the new rules create significant tax planning opportunities, the revised tax requirements for many vendors and purchasers mean that they are likely to be even further apart on deal structuring than they were before!

Peter Rayney FCA FTII TEP is a tax partner in BDO Stoy Hayward's Midlands office. He was recently awarded the Butterworths Tolley 'Tax Writer of the Year – 2002' Award.

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1: Incorporation transfer of goodwill

Mr Rudolph carried on a successful delivery business as a sole trader for many years. He decided to incorporate the business on 24 December 2002 by transferring the goodwill and the other trading assets to his newly formed company, Rednose Express Deliveries Ltd (RED Ltd).

The goodwill was sold to the company at its full market value of £200,000. However, RED Ltd would not be able to claim any Sch D Case I relief for its amortised goodwill under the FA 2002 IFAs regime. Although the company purchased the goodwill after 31 March 2002, it is acquired from a related party (Mr Rudolph) who held it on 1 April 2002. The goodwill therefore falls outside the ambit of the IFAs regime and remains within the corporate capital gains regime (para 118(1)(b)). (Incidentally, it should be noted that the purchase of goodwill, etc, is now free of stamp duty (s116, FA 2002).)

On the other hand, if the goodwill had been acquired or created by Mr Rudolph after 31 March 2002, the transfer to the company would be deemed to be at market value (irrespective of any actual price paid) (para 92 (1)). The goodwill would then be a CIA when acquired by RED Ltd. In such cases, there is nothing in the FA 2002 IFAs legislation that prevents tax relief being obtained by the acquirer.

2: Tax relief for purchase of IFAs

On 31 December 2002, In Dulci Jubilo Ltd acquired the trade and assets of Gaudete plc's high-tech sports equipment business. The purchase consideration was allocated as follows:

	£
Freehold property	1,500,000
Plant and equipment	1,100,000
Goodwill	500,000
Patent rights	800,000
Know-how	500,000
Trade debtors (net of trade creditors and other liabilities)	200,000
Net consideration, satisfied in cas	4,600,000

In Dulci Jubilo Ltd plans to amortise the acquired intangible fixed assets over the following periods:

	Years
Goodwill	5
Patent rights	10
Know-how	4

Clearly, the IFAs purchased by In Dulci Jubilo Ltd (the goodwill, patent rights, and know-how) fall within the FA 2002 IFAs regime, being acquired after 31 March 2002. (Note that know-how and patent rights purchased after 31 March 2002 no longer qualify for the capital allowances code.) Based on the company's proposed amortisation policy (and ignoring any future impairment write-offs, etc), it should be able to claim an annual Sch D Case I deduction of £305,000 on the relevant IFAs it purchases from Gaudete plc (starting with the accounting period to 31 December 2003), calculated as follows:

	Capital cost	Amortisation period	Annual write-off
	£		£
Goodwill	500,000	5 years	100,000
Patent rights	800,000	10 years	80,000
Know-how	500,000	4 years	125,000
Total	1,800,000		305,000

3: Treatment of patent royalties payable

During the year ended 31 March 2003, Frosty Ltd was charged patent royalties of £200,000. A summary of its patent royalties account for the year showed the following :

	£
Paid in year	170,000
Less: Accrued at 1 April 2002	(50,000)
Add: Accrued at 31 March 2003	80,000
Charge for year	200,000

The royalty accrual at 31 March 2002 falls to be deducted as a transitional adjustment in the accounting period ended 31 March 2003. Thus, in Frosty Ltd's case, £250,000 would be relieved in the year ended 31 March 2003, calculated as follows:

	£
Charge for year 200,000	170,000
Transitional relief for amount accrued at 31 March 2002	50,000
Sch D Case I deduction	250,000