The Internal Revenue Service recently released a memorandum addressing a taxpayer's attempt to change the character of a transfer of intellectual property (i.e., a patent) from a license to a sale in order to claim a loss ostensibly resulting from the transfer. The 37-page memorandum, Field Attorney Advice (FAA) 20075201F, released on December 28, 2007, can be summarized in the popular saying "a leopard can't change his spots." In other words, the taxpayer cannot recharacterize as a sale what is in essence a natural license of intellectual property (IP).
The IRS also stated that even if the taxpayer were successful in recharacterizing the transaction, the IRS would integrate the purported sale with a tax-free capital contribution made by the taxpayer to the transferee concurrently with the transfer of the patent and disallow the loss under the principles of Internal Revenue Code Section 351.
Taxpayers considering transfers of IP should study this FAA when structuring the license or sales agreement of a patent or other IP, and work with tax and legal advisors to ensure the desired results are achieved for both business and tax purposes. In doing so, they may well discover that their legal and tax advisers have different approaches to the issue that will need to be reconciled in light of the tax emphasis on economic or beneficial ownership of the IP.
While the FAA is not binding authority on the IRS, the factors considered and applied in the FAA provide a valuable insight into the IRS's analysis on IP planning, which now affects the global tax strategy of many multinational enterprises. The FAA will also be a useful tool for tax and legal departments when considering the factors that must be addressed in the controlling agreements. More importantly, the FAA serves as a reminder that taxpayers need to consider any IP agreements currently in place to ensure that the IRS will respect the characterization reflected therein in light of the requirements under FIN 48 (Financial Accounting Standards Board Interpretation No. 48). Any subsequent change to the characterization made by the taxpayer will be difficult at best.
A typical IP planning transaction may include a transfer or license of a patent or other IP related to foreign operations from the U.S. parent to its foreign affiliate. In general, the sale of IP to an unrelated party results in a capital gain or loss, whereas ordinary income is generally derived from licensing the IP. The IRS presented five reasons in the FAA why the taxpayer could not recharacterize the transfer of the IP as a sale:
The rest of this article focuses on the IRS's discussion of reasons (2), (4) and (5) dealing with what rights can and cannot be retained for a transfer of IP to qualify as a sale. Reasons (1) and (3) deal with general rules of contract construction and demonstrate the IRS's unwillingness to look beyond the four corners of the agreements to consider a taxpayer's argument that contradicts the chosen form of the transaction. The discussion in the FAA on these points is important and should be shared with legal advisors to emphasize the need for the documents to be unambiguous and explicit on the intent of the parties.
Selling IP
The transfer agreement considered in the FAA included a transfer of patents, of a sublicense of IP, of know-how and of other IP rights. The IRS identified several portions of the IP that were subject to pre-existing licenses, rights or limitations and that raised serious concerns for the IRS about the taxpayer's ability to sell these incomplete IP rights. For example, the IRS found that the taxpayer was a "mere licensee" of certain IP rights purportedly transferred under the transaction and could not "sell" IP rights that are simply an assignment of an existing license. Also, some of the patents that were supposedly transferred were subject to pre-existing licenses and agreements that were excluded from the transfer. Again, the IRS noted that a sale must grant all substantial rights given by the patent when issued, not just the rights remaining in the transferor at the time of the transfer. It is critical to examine the limitations and pre-existing contractual arrangements that exist around any IP that is being transferred or that was transferred to make sure the transfer is for "all substantial rights" and qualifies as a sale of the IP.
With respect to know-how, the IRS found that in order to achieve a sale, the taxpayer must transfer know-how in perpetuity and not just for the duration of the patent or other IP accompanying the transfer. It is not uncommon for the transfer of the know-how to be tied or related to the duration of the other IP, so all existing agreements should be reviewed to ensure that the know-how is transferred in perpetuity irrespective of the life or duration of the other IP transferred.
Another common practice may be to bundle a transfer of rights in a single contract that covers all the IP transferred. The IRS viewed the taxpayer's agreement as a whole, and refused to entertain the taxpayer's argument that certain rights transferred pursuant to a single agreement were sold and others rights under the same agreement were licensed. The IRS found that the law does not allow the taxpayer to cherry pick individual items within an agreement to create tax benefits that the agreement as a whole precludes. In light of these findings, taxpayers should structure the sale or license of IP in separate agreements, including in each agreement the particular factors that the IRS outlined in this FAA to achieve the desired result for each type of IP.
Transferring Monopoly Rights
For purposes of determining whether the taxpayer transferred a "monopoly" of the IP rights, the IRS found that the taxpayer must relinquish the following rights for a transaction to qualify as a sale: (1) perpetuity of know-how, (2) remaining duration of a patent, (3) dominion and control over IP, (4) the right to indulge infringements, and (5) fields of use.
As explained above, in the case of know-how, the transferor must transfer the know-how in perpetuity. According to the IRS's interpretation of the case law, the know-how is treated similar to a patent. However, there is an important distinction in that know-how has a perpetual life whereas a patent has a limited life. If the know-how is transferred in connection with a patent, which is often the case, one has to be careful not to limit the know-how to the life of the patent, based on the assumption that the know-how associated with the patent loses its value after patent's expiration date. In the IRS's view, the know-how does not expire with the patent and should continue in perpetuity.
In contrast to the know-how, a patent generally has a fixed duration, and the transferor must transfer the patent for its entire life to achieve a sale of the patent for U.S. income tax purposes. Retaining control over the IP transferred also serves as an indicator that the transferor did not intend to transfer ownership with all its incidental rights. Although it is clear that a sale will not result if dominion and control are retained, determining what comprises "dominion and control" is not. According to the IRS, examples of retained control are the right of first refusal for inventions, the imposition of reporting requirements for the transferee and the imposition of revenue goals for the sale of products associated with transferred IP.
The right to indulge infringement may be considered by some to be one of the most important elements in determining whether the IP was sold or licensed. The value of IP lies in the exclusive right to produce, develop or sell a product, and that right is usually carefully protected. The true owner of IP should have the right to sue or, more importantly, not to sue others for IP infringement. If any restrictions are placed on the right of the transferee to sue, or its ability to choose not to sue the infringer, then all the rights associated with IP may not have been transferred. To illustrate, a transferor that retains the power to sue infringers even if the transferee decides not to do so may be considered to retain the ownership of the IP and may not obtain sales treatment on the transfer. A legal department may take issue with this particular factor because in most intercompany transfers of IP, legal wants to retain the power and right to sue for any infringement with the U.S. transferor. Accordingly, the tax department will have to work closely with the legal department to draft the appropriate legal protections into the agreement to protect the IP rights and also meet the definition of a "sale" for tax purposes.
Transferring Field of Use
The final element considered in the FAA is the retained field of use. Field of use is a term of art that signifies the restrictions placed on IP that limit the use of IP, for example, to a particular industry. Fields of use restrictions allow the patent owners to control the way their invention is ultimately used. Therefore, if the transferor limits the use of IP or if the transfer is not exclusive (i.e., other persons have similar rights in IP), the transfer may be classified as a license.
However, it is important to distinguish a field of use restriction from a territorial limitation on the transfer of IP. Limiting the use of the IP to a particular geographic location is permissible and should not preclude "sale" treatment, provided that the monopoly of IP rights is transferred to the transferee for the designated geographic location. At the same time, transferring a particular field of use to a transferee may not be sufficient to achieve a "sale" for tax purposes.
Taxpayers and professionals should consider this FAA in relation to any contemplated IP transactions, given the consequences that may result from the IRS recasting the transaction as license rather than a sale or vice versa. Recasting the transaction can have significant consequences for the taxation of the transfer and the taxation of future flows of revenue from the IP.
Moreover, for FIN 48 purposes, the FAA provides insight into how the IRS will analyze transactions that purport to sell or license IP. This insight is invaluable in a post–FIN 48 world, given its imposition of the more-likely-than-not (MLTN) standard and greater disclosure requirements. Under FIN 48, assuming that the statute of limitations has not expired, taxpayers who entered into any IP transfer transaction should review that transaction to ensure that the reported characterization meets the MLTN standard. In carrying out this analysis, knowing how the IRS will analyze the transaction provides a benchmark and thus the much needed guidance often sought out in relation to FIN 48.
Finally, don't forget that a license of IP is typically treated as foreign source income for foreign tax credit purposes, whereas a sale would likely be U.S. source income. Therefore, the choice of sale versus license treatment for IP can also have a potentially significant impact on the "seller's" ability to use foreign tax credits.
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Juan Carlos Ferrucho
Managing Director, Miami
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Fernando Diaz, Director and Nadia Bustos, Senior Associate, contributed to this article.
Bill Hassell
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Al Liguori
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Mike Murphy
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