Under Canada’s tax laws, a taxpayer may deduct a “terminal loss” from its taxable income, where (i) the taxpayer has incurred a capital cost in acquiring property which may depreciate in value and (ii) the property has depreciated in value when the taxpayer disposes of the property. In order to claim the depreciation as a terminal loss, the relevant portions of the Income Tax Regulations provide that a taxpayer must have incurred a capital cost in acquiring beneficial ownership of the property, and that the property must have been acquired for the purpose of earning income. In the recent case of 568864 BC Ltd v The Queen, 2014 TCC 373, Justice Rip of the Tax Court of Canada considered whether a patent owner was entitled to claim a terminal loss for patent assets that had depreciated in market value. In so doing, the Court considered the separation of “beneficial” ownership from “legal” ownership of patent assets, and when a transaction involving beneficial ownership of the patent assets was effective for the purposes of the loss calculation.
The patents assets
The case related to patent assets including a U.S. patent application and a PCT application (claiming priority to the U.S. application) that claimed a method of making wooden trim boards of a desired length and width (collectively, the “Patents”). The Patents were originally owned by the principal shareholder of Interact Wood Products Ltd. (“Interact”).
Security interest and bankruptcy
The taxpayer, 568864 B.C. Ltd. (“568 Company”), who derived the bulk of its income from the sale of exterior trim boards and saw value in the Patents, received a security interest over the Patents in exchange for a loan of $3.5 million to Interact. The security agreement, dated December 19, 2003, described the security as “all right, title and interest in and to” all inventions and improvements described in the Patents. Interact and its principal shareholder, the owner of the Patents, filed for bankruptcy protection in July 2005 and August 2005, respectively. The Trustee in bankruptcy later released the Patents to 568 Company in November 2005, resolving that the release was “subject to an ultimate accounting for the proceeds of the disposition”.
Efforts to earn income
Following its acquisition of the Patents, 568 Company took a number of steps to put into practice the methods described in the Patents. In 2006, 568 Company purchased from Interact the production equipment required to practice the technology and also applied for national entries of the PCT application in numerous jurisdictions including Canada, Russia, China, Japan and Europe. Furthermore, 568 Company helped the Trustee finance an ultimately successful litigation against the common law spouse of the former owner of the Patents, who had claimed in a separate action that 568 Company’s security interest over the Patents was improperly created. 568 Company also made efforts to find a licensor or partner to engage in a joint venture to practice the Patents. However, 568 Company’s efforts were ultimately unsuccessful, and 568 Company decided to sell the Patents in 2007 to a related entity for the sum of $1.00, which it estimated as the market value of the Patents at that time. 568 Company then claimed a terminal loss for the value of the Patents, dating back to its acquisition of the Patents in November 2005.
Effective date of beneficial ownership
The government argued that the “subject to an ultimate accounting” language in the Trustee’s bankruptcy resolution meant that beneficial ownership did not vest in 568 Company as of the resolution and that, given that legal title to the Patents was not transferred to 568 Company until 2010, the taxpayer was not entitled to claim a terminal loss dating from November 2005. The Trustee in bankruptcy gave evidence that the “subject to an ultimate accounting” language was included so that, if a buyer could be found to pay more than the $3.5 million owing for the Patents, 568 Company could be repaid and any additional amounts could be paid to Interact’s unsecured creditors. However, any market for the Patents was complicated by a downturn in the wood products sector and the litigation relating to 568 Company’s security interest over the Patents, and no buyer was found. As such, Justice Rip found that the November 2005 transfer was not affected by the “subject to an ultimate accounting” language of the bankruptcy resolution.
Justice Rip found that the “beneficial owner” of property is one who can exercise the rights of ownership in the property or one who exercises all the “normal incidents of title, either actual or constructive, such as possession, use and risk”. This is true even if the property is registered in the name of another entity or the “legal title” is held in the name of another entity. Justice Rip found that 568 Company had absolute use, enjoyment and possession of the patents, taking into account the steps outlined above to exploit the Patents, even though they were ultimately unsuccessful. The Court also found that 568 Company assumed the risk associated with ownership of the Patents, having borne the legal expenses of defending the patent. Justice Rip concluded that 568 Company was the beneficial owner of the Patents.
The government also argued that even if 568 Company acquired beneficial ownership of the Patents in 2005, they were not acquired for the purpose of earning income and thus could not be claimed as a terminal loss. The Court disagreed, finding that the steps taken by 568 Company were incidental to ownership and its efforts to practice the Patents, originally on its own and later through attempts to license the Patents or to practice them through a joint venturer, were consistent with an intention to earn income and that the Patents were acquired for that purpose. The Court ultimately concluded that 568 Company was the beneficial owner of the Patents and was entitled to claim a terminal loss for the depreciation in value of the Patents dating back to November 2005.
This decision provides some guidance on the separation of “beneficial” ownership from “legal” ownership of patent assets, a concept which has been infrequently considered in Canadian intellectual property cases. The decision also highlights the importance of considering possible tax implications when structuring transactions involving patent assets. Properly structured, such transactions may enable taxpayers to enjoy the benefits of patent ownership while minimizing the resulting tax consequences.