High Court rules on the application of Section 4(f) of the ITA

In the recent grounds of decision in the case of Keysight Technologies Malaysia Sdn Bhd v Ketua Pengarah Hasil Dalam Negeri (Civil Appeal WA-14-4-03/2021), the High Court held that the sale of intellectual property from the taxpayer to its related company was revenue in nature and taxable under Section 4(f) of the Income Tax Act 1967(“ITA”). 

This case is perhaps the first written grounds in Malaysia regarding the application and interpretation Section 4(f) of the ITA. Whether right or wrong, the decision does deserve special attention on the application of Section 4(f) in the Malaysian judiciary. The case is now pending before the Court of Appeal.

Facts

The taxpayer was incorporated under the name Hewlett-Packard Microwave Products (M) Sdn Bhd in 1998. The taxpayer changed its name to Agilent Technologies Microwave Products (M) Sdn Bhd and again to Keysight Technologies Malaysia Sdn Bhd in 1999 and 2014 respectively, following two spin-offs by the taxpayer’s group of companies. 

The taxpayer had pioneer incentive status and was mainly in the business of manufacturing and marketing activities. Incidental to its principal activities, the taxpayer had developed technological know-how. 

In 2008, the taxpayer ceased to be a full-fledged manufacturer and converted into a contract manufacturer under a Manufacturing Services Agreement dated 1.3.2008 between the taxpayer and Agilent Technologies International s.a.r.l. At the same time, the taxpayer had sold, transferred and assigned all beneficial rights of protected and unprotected knowhow including manufacturing processes and intangible property rights (“Intellectual Property”) to Agilent Technologies Inc according to an Intellectual Property Transfer Agreement dated 1.3.2008 between the taxpayer and Agilent Technologies Inc. Agilent Technologies Inc paid the taxpayer RM821,615,000 in exchange for the Intellectual Property. 

This RM821 million was the subject of litigation. The Inland Revenue Board (“IRB”) had raised a notice of assessment for the Year of Assessment (“YA”) 2008 with penalty amounting to RM311 million. The main question was whether the sum of RM 821 million was taxable under Section 4(f) of the ITA. 

The Respondent was of the view that the sum of RM 821 million should be subjected to tax under Section 4(f) of the ITA for the following reasons: 

1. The transfer of technical knowhow was not an outright sale as the evidence should that the taxpayer was still using the technical knowhow in the manufacturing of its product after 1.03.2008; and

2. The gain on the transfer of technical knowhow for the payment on the loss of income was related to the change of the Appellant’s function from a full-fledged manufacturer to a contract manufacturer, which resulted in a reduction of profit margin for the taxpayer after the change of the function. 

The taxpayer appealed on the following grounds: 

1. The time bar under Section 91(1) of the ITA does not apply as the assessment was made 5 years after the expiration of the YA 2008 and the IRB had failed to establish negligence on the part of the taxpayer under Section 91(3) of the ITA;

2.The proceeds from the sale of the Intellectual Property are not revenue in nature and hence ought not to be taxed under the ITA; and

3.The IRB ought not to impose a penalty under Section 113(2) of the ITA.

The taxpayer was unsuccessful in its appeal before the Special Commissioners of Income Tax (“SCIT”) and they appealed to the High Court.

Decision

The Learned High Court Judge dismissed the appeal and upheld the decision of the Special Commissioners of Income Tax. 

If the 23-page judgment is too long for you to read, the TLDR is that the Learned High Court Judge found there was no outright sale of the Intellectual Property. It was reasonable for the IRB to raise the assessment under Section 4(f) of the ITA, impose a penalty under Section 111(2) of the ITA and that there was negligence by the taxpayer under Section 91(3) of the ITA.

The Learned High Court’s reason, as spanned across 12 out of the 23 pages of the grounds of judgment, focused on one finding of fact – there was no outright sale of the IP rights by the taxpayer. Amongst others, the taxpayer relied on 3 areas to prove that there was a transfer of IP rights:

1. Clause 3.4 of the Intellectual Property Transfer Agreement dated 1.3.2008 

3.4 Except as expressly provided in this agreement and to the fullest extent permitted by law, assignor hereby disclaims any and all warranties, express or implied, with respect to the technology, including but not limited to, any implied warranties or merchantability, fitness for a particular purpose, or non-infringement, and the parties agree that the technology is being transferred “as is”.”. 

2. Clause 7.1 of the Manufacturing Service Agreement 

7.1     Intellectual Property Rights Contractor hereby acknowledges that the Company or its licensor it the owner, or authorized licensee, of all rights in and to all of the Intellectual Property Rights, and Contractor shall acquire no rights whatsoever in or to any of such Intellectual Property Rights, except as specifically provided in this Agreement. Contractor shall not take any action that might impair in any way right or interest of Company in or to any of the Intellectual Property Rights”. 

3. Note 17(b) of the Statutory Financial Statements for the financial year ended 31.10.2008 which disclosed the sum of RM821,615,000 as “Transfer out of technical knowhow to a related corporation”. 

According to the Learned High Court Judge, the taxpayer’s witness had failed to support that there had been a transfer of intellectual property when put under cross-examination. 

Respondent: … Can you show the court the documents which finally the IP rights has been registered in the name of Agilent Technology?

Appellant witness: I don’t have them.” 

This was also one of the grounds on which the Special Commissioners of Income Tax in coming to the finding that there was no outright sale: 

We agree with the Respondent’s Submission… (the Appellant had failed) to support the claim that the gain from the transfer of technical knowhow (i.e. the marketing and manufacturing intangibles) by the Appellant to Agilent Technologies International totalling of RM821,615,000.00 is an outright sale.”

Commentary

  1. Was there an outright sale of the IP rights? 

I’m not going to delve into the nitty-gritty, but the taxpayer submitted that what is being transferred from the taxpayer to Agilent Technologies was “technical know-how”, which is non-registrable or patentable. As such, some rights are only protected by contract. 

From the grounds of judgment, it appears to me that the Learned High Court Judge was not satisfied that there was an outright sale as there was no legal transfer of the IP Rights, but although it agreed that beneficial ownership has passed.

If it is not an outright sale, the question then begs as to the purpose of the sum of RM821 million. For a consideration valued at RM821 million, surely it must be for something valuable? Unfortunately, neither the Special Commissioners of Income Tax nor the Learned High Court Judge dealt with this in detail. However, it is the Respondent’s case that the amount relates to loss of income based on badges of trade as the valuation is the projection of the taxpayer’s net income. The SCIT and the High Court upheld this reasoning; hence I’ll assume this to be their reason. 

2. Is the sum of RM821 million representing the “loss of income” revenue?

Relating to the badges of trade, is “loss of income” one of the badges? Although the categories of the “badges of trade” are not closed, it does not appear that “loss of income” is a clear category. Even if there is no outright sale, the sum is not revenue because the payment is nevertheless depriving the taxpayer of a permanent “loss of income” that it would’ve received if it had continued to own the beneficial ownership of the asset. 

Two cases are worth considering and contrasting here: Burmah Steam Ship Company, Limited v The Commissioners of Inland Revenue 16 TC 67 vs The Glenboig Union Fireclay Co, Ltd v The Commissioners of Inland Revenue 12 TC 427

In Glenboig Union, the taxpayer carried on business as manufacturers of fireclay goods and as merchants of raw fireclay. Subsequently, there was a dispute between the taxpayer and the railway company, and the taxpayer was interdicted from working under the railway. The railway company lost in the action, and the House of Lords exercised its statutory powers to require a part of the fireclay to be left unworked on payment of compensation. It was immaterial that the compensation was computed by the loss of expected profit from the inability to but that the compensation was ‘the price paid for sterilising the asset from which otherwise profit might have been obtained’.

Lord Dundas held as follows: 

In the first place, what we must consider is not the measure by which the amount of compensation was arrived at, but what it was truly paid for, and, as already indicated, I think the compensation was paid for the loss of a capital asset. In the second place, and this is perhaps just another way of stating the same thing, the sum can surely not be described as profits arising from the Appellants’ trade or business; for it arose not from the exercise of that trade but in respect that the Appellants were prevented from dealing in their business with, and earning any profits from, a portion of their mineral estate.”

Lord President (Clyde) also held:

“It was argued that the compensation payable to the Company, being measured by the present value of the profits which the Company might, and in all reasonable probability would, have made if the leasehold had not been interfered with, was really a consideration or substitute But, even so, it is a consideration or substitute, not for profits earned or capable of being earned, but for profits irretrievably lost and incapable of being ever earned. The taxing acts deal with profits made, not with profits lost – with actual, not with hypothetical profits – and it is by the words of the taxing acts that we are bound. As paid to and received by the Company, the compensation was the equivalent of a destroyed portion of one of its fixed assets: I do not think it was a profit which arose from the Company’s trade or business at all.”

In the case of Burmah Steam Ship, the taxpayer bought a vessel and sent it for overhaul. The time stipulated for the overhaul exceeded the agreed timeline, and the taxpayer claimed from the repairers damages based on the estimated profit which would’ve been earned had the vessel. In finding that the compensation was taxable, Lord President Clyde distinguished the case of Glenboig Union and this instant by holding that: 

Now, in the present case, the injury inflicted on the Appellant by the repairer’s failure to make timeous delivery of the vessel is obviously not an injury to the Appellant’s capital assets. Time sounds in money no doubt, but the loss to the Appellant by the late delivery was in the form of loss of trading opportunities, not in the form of the loss of fixed capital….

It is true that the measure by which the amount of damages or compensation is ascertainable is no criterion of the capital or revenue character of the sum recovered for the purpose of adjusting an Income Tax account of profits and gains (Glenboig Union Fireclay Coy. v Inland Revenue 1, 1921 S.C. 400, 1922 S.C. (H.L.) 112)… In the present case there can be no doubt that, when the Appellant entered into the contract with the repairers, the consequences of a failure by the latter to deliver punctually, which were in the contemplation of both parties at the time, were that the Appellant would be deprived of the opportunity of putting the vessel to immediate profitable use in his business. It was in respect of this deprivation that the damages were recovered. The contemplated “hole” in the Appellant’s profits was unfortunately made, and in my opinion the damages recovered must go, as a matter of sound commercial accounting, to fill that “hole”, and therefore constitute a proper item of profit in the Appellant’s profit and loss account.”

If the compensation given is due to permanent damage to a capital asset, TLDR is capital in nature. In contrast, if the compensation is due to temporary disturbance, it is revenue. If the argument goes along the lines that there was no outright disposal and the compensation is for “loss of income”, it is nevertheless not revenue in nature. Either way, the sum of RM821 million should not be taxed under Section 4(f) of the ITA for the reasons below. 

3. Is the sum of RM821 million taxable under Section 4(f) of the ITA?

It is unfortunate that neither the High Court nor the Special Commissioners of Income Tax dealt with this question in detail and overly focused on whether the taxpayer sold IP rights. Section 4(f), the “catch-all” provision, was meant to be a receptacle into which various revenue receipts wished to be added but did not belong elsewhere. 

In the leading case of Leeming v Jones [1930] 1 K.B. 279, Rowlatt J held that gains falling under Case VI Schedule D, the pari materia of our Section 4(f), must be revenue in nature. In this instant, the taxpayer was invited and agreed to join a syndicate to acquire an option over a rubber estate. The estate was not large enough for re-sale, and the syndicate acquired a further option to purchase an additional estate. The two estates were sold at a profit for which the taxpayer was assessed to tax.

Rowlatt J. held as follow in this instant case: 

.. and although you may have cases which fall properly within Sch. D and in respect of which case VI. may be usefully applied, yet if you are to apply Case VI. it must be in respect of something to which Sch. D applies; it must be something in the nature of profits or gains in contradistinction to capital, and I think that the words which are used by Atkin L.J. in Cooper v. Stubbs (1), to which I have already referred, are of assistance here, for he made it plain that he regarded Case VI.

His Lordship further expanded on what would not be caught under Case VI:

We have to bear in mind what I think Rowlatt J. has rightly said in Ryall v. Hoare (2): “Two kinds of emolument may be excluded from Case VI. First, anything in the nature of capital accretion is excluded as being outside the scope and meaning of these Acts confirmed by the usage of a century. For this reason, a casual profit made on an isolated purchase and sale, unless merged with similar transactions in the carrying on of a trade or business is not liable to tax. ‘Profits or gains’ in Case VI. refer to the interest or fruit as opposed to the principal or root of the tree.”

Leeming v Jones had referred to and distinguished the previous case of Cooper v. Stubbs [1925] 2 K. B. 753. Cooper had earlier alluded to the possibility of taxation of capital accreditation under Case VI. Still, subsequent cases interpreted this as giving rise to trading rather than miscellaneous income depending if the activity was speculation or organised as a trade.

I think both the judgments in Cooper v. Stubbs (1) which are relied upon clearly indicate that the learned judges in dealing with Case VI. were definitely holding that there must be some profits or gains in the nature of revenue, as contradistinguished from a profit arising upon capital.”

Based on the analysis above, for an income to fall under Section 4(f) of the ITA, the income must be first and foremost revenue in nature. It is the fruit rather than the tree. For a corporation mainly involved in the manufacturing industry and had developed technical production know-how, that technical know-how should be a capital asset of the corporation. Hence, the subsequent disposal is capital in nature. 

3. Inconsistencies in the application of the law

Say that the income is taxable under Section 4(f) of the ITA, the IRB should’ve made appropriate adjustments according to the taxpayer deductions under Section 33 of the ITA. The deductible expenses, in this case, would be labour, research and development expenses and miscellaneous in developing the technical know-how. However, the IRB did not allow deductions, and neither did the SCIT and the High Court similarly hold, which to my mind, is gravely flawed. 

Furthermore, the IRB reasons that because the taxpayer had continued to use the Intellectual Property which it had sold in the course of business, the income is revenue don’t equate well. The principle that is well settled is that the IRB doesn’t have the power to command how taxpayers ought to carry out their business (Port Dickson Power). Hence, if the sale was superficial, it ought to make the necessary adjustments under Section 140A of the ITA, which would be reflective of arm’s length transactions. The utilisation of Section 4(f) of the ITA was, to my mind, inappropriate in this case. 

Author: Sophia Choy

I am lawyer-turn-consultant writing about the latest tax changes in Malaysia. Pretty much the most dynamic scene in any law in Malaysia. Talk to me about tax at choycaiying@gmail.com.

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