NEW TAX RULES FOR IN-VESTMENTS OF TECHNOLOGY

03/01/2005

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On 7 January 2005, the Legislative Yuan enacted amendments to the Industrial Upgrading Act (IUA). Two new provisions were introduced: Articles 19-2 and 19-3, which provide criteria for the taxation of equity contributions made in the form of patent or know-how. This change to the law was prompted by a legal interpretation is-sued by the Ministry of Finance on 1 October 2003, which stated that from 1 January 2004, when equity is contributed to a company in the form of intangible assets such as technology, any amount by which the value of the shares acquired exceeds the cost of acquisition of the contributed assets will be treated as taxable income, and should be declared as income for the year in which the transaction takes place.

This ruling prompted widespread criticism from industry, which complained that at the time of an equity contribution the income from it is as yet unrealized, so that taxation at that point would create an unreasonable burden. Businesses felt that the MOF's view was not conducive to the development of the knowledge based economy and of human resources. In response, the Min-istry of Economic Affairs proposed amendments to the IUA to adjust the relevant tax regime.

Article 19-2, effective retroactively from 1 January 2004, provides that if equity is contrib-uted to a Taiwanese company in the form of patent or know-how that are transferred or li-censed to the company, payment of income tax may be deferred for five years on condition that the MOEA confirms that (1) the invested com-pany is in an emerging industry, and the patent rights or technology so acquired are for its own use; and (2) the shares acquired by the equity contributor(s) account for at least 20% of the company's total issued shares after the transac-tion, and (3) no more than five shareholders par-ticipated in the equity contribution. But if the shares are disposed of within five years, tax will become payable at the time of their transfer.

Article 19-3, also effective retroactively from 1 January 2004, provides that if the board of a Taiwanese emerging-industry company decides, by majority resolution of a meeting attended by at least two thirds of the directors, to issue stock warrants to an investor that makes an equity contribution in the form of patent or know-how, then income tax will be assessed in the fiscal year in which the stock warrants are exercised. The year in which stock warrants are exercised may be more or less than five years after they are is-sued, or by that time shares in the company concerned may have become worthless, so that the equity contributor decides not to exercise its subscription rights. Thus under Article 19-3 the tax point may be earlier or later than that under Article 19-2, or it may be that no tax liability arises because the warrants are not exercised.

The basic aim of the above two new articles is to moderate the stance taken in the MOF's inter-pretation, that the income should be treated as being realized in the year in which the shares are acquired, and should be taxed in that year. In-stead, the position adopted is that income tax should be assessed in the year when shares are acquired, but should not be collected in that year; or if stock warrants are acquired rather than shares, no income is ascribed to the year when the stock warrants are acquired, but the year when they are exercised is treated as the year in which income is realized and taxed.

When considering the implications of the new legislation, the following issues should be borne in mind:

The new IUA provisions refer only to equity contributions in the form of patent and know-how. This is much narrower in scope than the "intangible assets, such as technol-ogy" referred to in the MOF interpretation, which covers equity contributions in the form of all kinds of intangible assets, such as trademarks or commercial goodwill.

Know-how is defined as technical methods, and does not include technical services. The difference is that income derived from the former is classed as "income from property transactions," while the latter is classed as "remuneration for services," or as "other in-come." An equity contribution in the form of technical methods is a contribution of property, whereas an equity contribution in the form of technical services is a contribution of services. Equity contributions in the form of technical services are not addressed by the MOF inter-pretation referred to above, and do not fall within the scope of the IUA provisions.

An "emerging industry" is not the same as an "emerging strategic industry" as referred to in Articles 8 and 9 of the IUA. Therefore it is not possible to judge what sectors this includes on the basis of the sectors listed in the Regula-tions Governing Incentives for Emerging Strategic Industries as Applicable to Manu-facturing and Technical Service Industries. Instead, the included categories will be de-cided by the MOEA in consultation with other relevant agencies.

With regard to the calculation of taxable in-come, Article 19-2 of the IUA provides that in the case of shares obtained in exchange for an equity contribution, the income on which tax may be deferred is the "income calculated according to the provisions of the Income Tax Act." Article 19-3 provides that in the case of stock warrants obtained in exchange for an equity contribution, "any amount by which the current market price of the underlying shares exceeds the subscription price" is to be treated as taxable income. Under Article 19-2, the valuation principle applied is that if the shares have a market price they should be valued at the market price, and if they have no market price they should be valued at their par value or their net value. Article 19-3 expressly provides that income is to be calculated on the basis of the shares' market price at the time the stock warrants are exercised. But in the vast majority of cases, shares obtained by a con-tribution of equity have no market price. Thus it seems likely that here too it will be neces-sary to fall back on the shares' net value on the date when the stock warrants are exercised, or perhaps under certain circumstances on their par value. We will have to wait and see how the tax authorities' practice develops in this regard.

In the case of an equity contribution by an individual owner of patent or know-how, if the owner is unable to document the cost of ac-quiring the technology concerned, for the purposes of calculating income the cost will be assumed to account for 30% of the subscrip-tion price of the shares obtained, or, if stock warrants are obtained, 30% of the balance of the underlying shares' market price on the date when the warrants are exercised, less the subscription price. In other words, in both cases the income is calculated at 70%.

With regard to tax collection, the new provi-sions require that a company must report tax data to the tax collection authorities by the end of January in the year following that in which a shareholder disposes of shares, or in which the tax deferment period expires, or in which subscription rights are exercised. Failure to do so will attract the penalties provided for by Article 111 Paragraph 2 of the Income Tax Act.

To analyze the tax outcome of the above provi-sions, the amount of equity contribution is as-sumed to be equivalent to the value of the shares directly acquired, or of the stock warrants ini-tially acquired. Thus the subscription price de-fined by stock warrants may be simply a sym-bolic figure, such as NT$1. This is why Article 19-3 provides that the stock warrants are not subject to the requirement under Article 140 of the Company Act that their price may not be less than the par value of the underlying shares.

From the above we can see that if at the time when an equity contribution is made the value of the shares concerned is NT$100, and the shares are taken directly, then income is calculated on the basis of the current value, i.e. NT$100, but tax payment is deferred for five years. At the end of five years the tax becomes due, even if the shares have by then become worthless.

Conversely, if initially stock warrants are issued, and the subscription price is set at NT$1, this implies that at the time when the equity contri-bution is made, the company has paid the owner of the patent or know-how income to the value of NT$99, and in the future the equity contributor will be able to obtain shares currently valued at NT$100 for a further payment of NT$1. But the NT$99 is not calculated as current income, be-cause the new Article 19-3 forbids the transfer of such stock warrants, thus preventing the income from being realized unless the stock warrants are exercised. Whether or not any taxable income arises is determined on the basis of the shares' value at the time of subscription. If at the time the stock warrants are exercised, the shares' value has fallen to NT$60, then taxable income will be calculated at only NT$59.

Thus not only is the time point at which tax is collected different under each of the two new articles, but the tax outcome also differs. Sup-pose that by the time the stock warrants are ex-ercised the shares' value has risen to NT$150. If the equity contribution had been directly ex-changed for shares the NT$50 increase over the initial value would have been an income-tax-free securities capital gain. But if stock warrants are taken, the taxable income arising from the equity contribution goes up to NT$149.

In addition, Article 4 Subparagraph 21 of the Income Tax Act provides that under certain conditions, royalties paid to a foreign for-profit enterprise for the use of its patent, trademark, or other licensed rights, are exempt from income tax. "Other licensed rights" includes know-how. One of the criteria for this exemption is a con-tractual stipulation that the rights granted are not contributed as equity, but that a certain level of royalties or remuneration is to be paid. There-fore, when a foreign business licenses patent or know-how to a Taiwanese business, the transac-tion will be taxable or tax-free depending on whether it involves an equity contribution or pure remuneration in the form of royalties. However, the above MOF interpretation, and the new IUA provisions, apply only to equity con-tributions.

Furthermore, according to the MOF interpreta-tion, income from equity contributions in the form of intangible assets is to be treated as "in-come from property transactions." This term may previously have referred solely to transac-tions involving transfer of ownership, but the interpretation does not explicitly address this point. The IUA now expressly applies the term both to ownership transfers and to licensing ar-rangements, and this will create the same tax outcome for both property transaction income and royalty income. In terms of tax liability for Taiwanese companies, this "blurring" of the dis-tinction between the two is unlikely to result in signification difference.

However, for foreign taxpayers, doubt may arise. For instance, if a foreign company transfers for-eign patent or know-how to a Taiwanese com-pany in exchange for shares, since the property is not located in Taiwan, the income will not be classed as income from an ROC source. How, then, should the tax outcome be determined? Also, what is the justification for treating cash received in exchange for the licensing of rights as royalty income, but treating shares received as property transaction income?

The basis for determining whether royalty in-come is income from an ROC source is whether the rights concerned are licensed for the use of others within the ROC. Does the fact that the IUA provides for deferred taxation of both roy-alty income and property transaction income imply an intention to narrow the scope of the Act's provisions on the taxation of equity con-tributions, by limiting them to contributions of assets located in Taiwan? If so, what legislation covers contributions of assets located outside Taiwan, and what are the tax consequences? These issues, along with the question of whether current market price, net value, or par value should be used as the basis for calculating in-come, as discussed above, would appear to re-quire further clarification.