Vanessa Tollis, Attorney at Kilpatrick Townsend & Stockton LLP
Overview
In today's world, a company's most valuable assets often are its intellectual property, including patents, trade secrets, trademarks, and copyrights ("IP assets"). Because IP assets are intangible, their movement from one company to another, including from one country to another, is often as simple as signing a few transfer documents, particularly for an intragroup transfer. However, the simplicity is deceiving. For example, while the act of transferring patent assets is easy, it can be fraught with legal and tax implications. Typically, patent lawyers are involved with the transfer planning and documentation, as they should be since legal protection of patent assets is paramount to their value.
Too frequently, however, tax advisors do not also participate in the process, even though a transfer of patent assets can result in very different tax consequences depending on precisely how the transfer is structured. Instead, tax advisors may only become involved after the transaction has closed, typically when it comes time to report the transaction or its consequences on a tax return. By then, it generally is too late to undo any tax inefficiencies, or even mistakes, that could have been easily addressed at the planning phase. However, a relatively small investment in tax planning at the front end of a patent asset transfer transaction can often result in significant savings, initially and even over the useful life of that patent asset.
This discussion aims to provide company executives who are not tax professionals with an overview of key tax points relevant to the transfer of patent assets. This knowledge will permit them to know why, and when, to involve their in-house tax colleagues or external tax advisors in such transactions. Discussion points include explaining critical tax ownership concepts, their impact on the tax characterization and tax consequences of different types of transfers, including sales, licenses, contributions, and cost sharing arrangements.
Tax Ownership
Patent and tax professionals can speak a different language when it comes to the transfer of patent assets, although they might not realize it. Identifying disconnects in the otherwise common terminology is the first step to coordinating an efficient patent and tax result to a transfer of patent assets.
Ownership is one of the most fundamental yet complicated concepts in tax law. The concept primarily relies on case law, and not statute. Simply stated, tax ownership rests with the party possessing the economic "benefits and burdens" of ownership associated with a particular asset, often referred to as a bundle of rights. The party holding most, or all, of that bundle of rights generally is the tax owner of that asset. Over the years, the courts have cited multiple factors as influential to the tax ownership analysis. See e.g., Grodt & McKay Realty, Inc. v. Commissioner, 77 TC 1221 (1981).
While no one factor is dispositive, it is well accepted that elements such as the right to profits from operation, sale, or sublicense of the asset, and bearing the risk of loss or damage are influential features indicative of tax ownership. Generally, the party with the right to control the economic aspects of the asset, and holding the opportunity for either gain or loss, is the tax owner of that asset. Importantly, for tax purposes, a patent asset often is divisible into components, each of which might have different tax ownership. A typical division is one based on geographical rights. A common scenario involves a US party as the tax owner of the US rights and a foreign party as the tax owner of the foreign rights. See e.g., Waterman v. Mackenzie, 138 U.S. 252 (1891).
Characterizing a Transfer of Patent - Is it a sale or a license?
The tax characterization of a transfer dictates its tax consequences. The IRS can intervene to recharacterize a transfer according to its substance, regardless of how the parties may have characterized, labeled, or treated the transfer for tax and other purposes. Consequently, it is imperative that the substance of a patent asset transfer match the intended tax characterization. A patent asset transfer that is labeled as a license but that is, in substance, a sale for tax purposes risks being recharacterized as a sale upon review by the IRS. See, e.g., Kavanagh v. Evans, 188 F.2d 234 (6th Cir. 1951) (a full "license" of all rights to manufacture, use, and sell products covered by a patent for the full life of the patent was found to be a sale of the patent). Importantly, the fact that the transfer may, for all other legal purposes, be recognized as a license, has little bearing on the proper tax characterization of the transfer. The only rules that really matter in the tax world are the tax rules.
Further, the characterization of a transfer is a sale or a license for tax purposes depends on whether the tax ownership of the asset has been transferred. Consequently, the tax characterization of the transfer ties directly to the tax ownership concepts discussed above. If, taking into account all the relevant facts and circumstances, the transfer is of substantially all of the economic bundle of rights to the patent asset (i.e., the benefits and burdens of ownership), then a sale for tax purposes is the appropriate characterization. See e.g., Rohmer v. Commissioner, 153 F.2d 61 (2nd Cir. 1946); Tomerlin Trust v. Commissioner, 87 T.C. 876 (1986). This result is often the case even when the contract itself is clearly labeled and structured as a license for all other legal purposes. For example, an exclusive, perpetual license of all economic rights and risks to a patent asset results in a sale of the asset for tax purposes. However, if less than all substantial economic rights to the patent asset are transferred, the transfer generally is a license. See e.g., Walen v. United States, 273 F.2d 599 (1st Cir. 1959); Kimble Glass Co. v. Commissioner, 9 T.C. 183 (1947). A non-exclusive or limited term license to use a patent asset typically is a license for tax purposes because the licensor retains substantial economic rights, including the ability to license or sell the patent asset to others. The structure of the transfer payment, whether made as an upfront lump sum payment or a series of payments, is not relevant to the characterization of the transfer. While nomenclature and intent are factors taken into consideration in the overall tax ownership analysis, the mere fact of having labeled a payment as a royalty, license fee, or purchase price will not suffice alone to make the transfer a sale or a license for tax purposes. Commissioner v. Wodehouse, 337 U.S. 369 (1949).
Why Does Characterization Matter?
Whether the transfer is a sale or a license impacts the tax consequences, including the kind of income earned and the source of such income. These classifications in turn affect issues like withholding taxes (if a payment is across borders), use of foreign tax credits, availability of loss offset, allocation of deductions, and other tax factors all of which have a real dollar impact depending on the tax position of the taxpayer.
For tax purposes, a license of patent assets generates royalty income taxed as ordinary income. Royalties for the right to exploit patent assets outside of the US are treated as foreign source royalties whereas royalties to exploit patent assets within the US generally are US source royalties. US source royalties paid to foreign counterparties generally are subject to a 30% withholding tax unless a double tax treaty can apply to reduce or exempt the payment from withholding tax.
By contrast, a sale of patent assets typically generates capital gain or loss, with the gain amount calculated as the difference between the tax basis in the asset (i.e., cost) and the sale price. Gain generally is sourced according to the residence of the seller, and thus generally is not subject to withholding tax when sold by a foreign entity.
Beyond Sales and Licenses
Another common method of transferring patent assets is contributing the patent assets, either to a joint venture partnership in exchange for an ownership interest, or to a corporation in exchange for stock. In a purely domestic context, such contributions are often tax free (provided that, in the corporate context, the corporate affiliate is at least 80% controlled after the contribution). In that case, the transferor partner or shareholder generally will have a tax basis in their new ownership interest or shares equal to the transferor's tax basis in the contributed patent assets and there is no immediate tax impact to the transferor. If that same contribution is to a foreign corporation, however, the US tax rules dictate a very different result. Instead of being tax free, the US transferor is treated for tax purposes as having sold the patent assets in exchange for deemed royalty payments. These payments are calculated to reasonably reflect the value of the productivity, use or disposition of the patent asset, and they are deemed to be received annually over the useful life of the patent asset. Notably, this is a notional income concept - meaning the US transferor will have a tax liability relating to income that it will never actually receive. See I.R.C. § 367(d). This shockingly punitive result illustrates the pitfalls of proceeding with a patent asset transfer, particularly across borders, without first assessing the tax consequences. While somewhat less punitive, contributing a patent asset to a foreign partnership also is fraught with complicated tax considerations that must be vetted well before implementation.
A cost share arrangement ("CSA") is an alternative approach to transferring a patent asset to a foreign affiliate without actually selling, licensing, or contributing the patent asset in the traditional sense. A CSA is a construct of the US tax rules permitting a US company to enter into a qualifying CSA with a foreign affiliate so that the two companies can share the costs, risks, and benefits of co-developing patents. See e.g., I.R.C. § 482; Treas. Reg. § 1.482-1, et. al. The CSA rules prescribe specific methods to calculate and allocate each party's costs and income in proportion to their development and exploitation of the patent asset. This approach typically allocates tax ownership of foreign rights to the foreign affiliate and US rights to the US company, with the inception of the arrangement requiring a "platform contribution" of an existing patent asset to the CSA by at least one party and payment for same by the other party. Although complex and often expensive to implement and maintain due to the rigid requirements of the CSA rules, this approach is often tax efficient for a multinational company with ongoing development and exploitation of valuable patent assets. However, because CSAs exist only in the domain of the tax law, this approach may not be considered or known as an option without including a tax advisor in the conversation.
Balancing Tax Efficiency Against Enforcement
Another common disconnect to note is enforcement. Pursuant to patent law, the legal title owner generally is the party with the right to bring an enforcement action. An exclusive licensee may join the action, but a non-exclusive licensee generally is not permitted to join. Consequently, to claim lost profits, either the legal title owner or the exclusive licensee has to earn those profits. If tax planning is carried out in a vacuum apart from patent enforcement concerns, the wires can easily get crossed such that the profits, while nicely placed for tax efficiency, will not be situated to allow claim of lost profits in an enforcement action. For example, if tax advisors structure a plan to move tax ownership of a patent asset to an affiliate in a lower tax country in order to achieve a targeted group effective tax rate, that movement of economic ownership and profits may inadvertently compromise the enforcement options available to the company with respect to that asset. The benefits of tax structuring can easily be in tension with the requirements of legal enforcement, providing yet another good reason to ensure good communication between patent legal advisors and tax advisors.
Conclusion
Importantly, numerous other tax concepts are worthy of attention including transfer pricing and the arm's length standard, valuation issues, and the current changing landscape across the European Union and elsewhere regarding taxation and movement of patent assets (in particular the "Base Erosion and Profit Shifting" initiative currently influencing legislative developments around the world relating to taxation of patent assets). However, with a little bit of knowledge and some communication, it is absolutely possible for legal and tax concerns around patent assets to live in harmony in a functional and tax efficient structure. Developing a sensitivity to tax issues among all professionals in a position to deal with transfers of patent assets makes sense and can ultimately save tax costs.
Additional Resources
Legal Alert: IRS Strikes Favorable Tax Treatment of Outbound Transfers of Foreign Goodwill and Going Concern Value
Legal Alert: Innovation Promotion Act of 2015: Is the United States Finally Getting Competitive in the Patent Box Arena?
Tax Considerations of Acquiring Intellectual Property, Journal of Taxation, October 2014
Taxation of Intellectual Property, Lynn E. Fowler, Don Reiser, Jerry N. Smith http://www.oecd.org/tax/beps/
