In a rare appellate decision which takes a look at the intersection between tax and intellectual property, the Court of Appeal has held that gains arising from the disposal of intellectual property rights constitute capital gains and are therefore not taxable in nature.

This is a landmark decision which has significant implications for the tax treatment of intellectual property disposal and has the potential to disrupt any attempt the Inland Revenue Board (“IRB”) to tax such gains as income.

In this case, Keysight Technologies Malaysia Sdn Bhd (“Keysight”) initially operated as a full-fledged manufacturer of various microwave devices, test accessories, amplifiers and transceivers. Over time, it developed technical know-how with regard to both the manufacturing and marketing of such products (the “IP Rights”).

Following a restructuring exercise, Keysight transitioned from a full-fledged manufacturer to a contract manufacturer for Agilent Technologies International Sarl (“Agilent”). As part of the restructuring, Keysight divested its IP Rights to Agilent via an intellectual property transfer agreement. However, in order for Keysight to continue operating as a contract manufacturer for Agilent, Keysight was granted a licence by Agilent to use the IP Rights for the sole and exclusive purpose of contract manufacturing for Agilent.

The gains which were made by Keysight by reason of having divested the IP Rights to Agilent were reported as a capital gain which was not taxable in nature in 2008. In August 2013, the Respondent, which was the Inland Revenue Board of Malaysia (“IRB”), initiated a transfer pricing audit on Keysight. No transfer pricing issues were raised, but in March 2017, IRB contended that gains made by Keysight from the sale of the IP Rights in 2008 were income which was taxable in nature – and claimed that Keysight was negligent in failing to report the same. A notice of additional assessment together with a 45% penalty was therefore issued against Keysight.

Dissatisfied, Keysight appealed to the Special Commissioners of Income Tax (“SCIT”), and later, the High Court, but both the SCIT and the High Court ruled against Keysight, finding, amongst other things, that:-

1. the “badges of trade” test, which was applicable for the purpose of distinguishing between capital and income, was only applicable to the disposal of land or property and not intellectual property;
2. the gains from the sale of the IP Rights were income in nature on the basis that “only the beneficial rights to the IP” were transferred to Agilent, not the legal rights; and
3. there was no evidence that legal title in the IP Rights had been registered in Agilent’s name pursuant to the sale, and Keysight continued to make use of the IP Rights.

Keysight then appealed to the Court of Appeal, which was tasked with determining, among other issues, whether the gains from the sale of the IP Rights were capital or income in nature.

With regard to this issue, the Court of Appeal disagreed with the lower tribunals, holding that the badges of trade test is not limited to land or tangible assets and can indeed apply to intellectual property. In this instance, Keysight was not in the business of selling intellectual property, and the disposal of the IP Rights was a one-off transaction carried out in connection with the corporate restructuring. As such, the gains were capital in nature.

The Court also found that the SCIT and High Court had erred in finding that legal rights have not been transferred. The intellectual property transfer agreement contained clear and unequivocal provisions on the transfer of ownership of the IP Rights to Agilent.

The Court also rejected the contention that the transfer of the IP Rights was incomplete due to the absence of evidence of registered legal title in Agilent’s name. As any intellectual property practitioner would be aware, the IP Rights in question consisted of technical know-how, which—unlike patents or trademarks—are not subject to registration, nor are they registrable in nature. Such rights are protected through confidentiality and contractual obligations, not by way of registration.

This decision by the Court of Appeal not only clarifies the tax treatment of gains arising from the disposal of intellectual property rights but also sets an important precedent for future transactions. It also provides a safeguard against the arbitrary taxation of legitimate corporate restructuring exercises involving intellectual property and underscores the importance of assessing such matters based on legal substance and commercial context.