2013-Issue 21—Intellectual property (often abbreviated as IP) covers patent, copyright, trademark, and other forms of technical or proprietary information, know-how and trade secrets. IP is increasingly becoming a valuable business asset. IP disputes are also becoming more common and carrying higher stakes. The well-publicized litigation between Apple and Samsung about the designs of smartphones and tablets is just one recent example of a headline-grabbing IP dispute between companies. Pick any two major technology companies whose operations overlap or intersect in some way, and chances are that you will find some kind of legal battle between them. Frequently, these disputes involve the laws of several countries. Even mid-sized companies in more traditional lines of businesses often find themselves embroiled in IP disputes about trademarks, brand names and product designs, to name just a few.

In any IP litigation, the tax treatment of the amounts paid or incurred in the litigation (such as settlement payments or legal fees) could make a substantial difference for both parties. For the party receiving a settlement payment, the payment could be treated in whole or in part as ordinary income, capital gain, the tax-free recovery of an asset or a combination of the three. As a result, the net after-tax recovery may be significantly different depending on the applicable characterization and allocation of the settlement. For the party making a settlement payment, the payment could be deductible in part or it may be capitalized in part. If capitalized, the amount may be amortizable. Similar issues also apply to legal fees incurred by both parties.

While the resulting settlement of IP litigation may not make either party happy, a lack of attention to the related tax issues could make the parties feel even worse. In this article, we focus on the tax treatment of settlement payments in IP litigation, and suggest that proper tax planning during the litigation and settlement process may help maximize after-tax recovery or minimize the after-tax costs.

General Considerations 
The same tax rules apply whether litigation is resolved through a court decision, judgment at trial or a mutually agreed-upon settlement (whether before or after the start of litigation). In each of these situations, payments and expenses are both characterized and treated for federal income tax purposes in accordance with the underlying legal claims and the damages or recovery for which the payments represent, generally without regard to the purpose or motivation of the taxpayer making the payment or incurring the expense. This approach is known as the "origin of the claim" doctrine.

A related corollary is that payments and expenses that are attributable to the defense or perfection of IP rights, or to the sale, acquisition or assignment of such intangible assets, generally must be capitalized, even if the purpose of the resolution is to avoid the continued hassles, distractions and costs of litigation.

Most IP disputes involve multiple issues and legal claims. For example, a simple trademark infringement case will often raise issues related to title and ownership, such as priority of commercial use or validity of any registered mark, in addition to claims about infringement and unfair competition. Moreover, the resolution of an IP dispute will often involve an IP licensing or transfer in addition to any standard settlement agreement that terminates the legal claims and disagreements. Accordingly, IP litigation settlements can result in several potential alternative tax characterizations and allocations, with different tax treatments for the payments received or expenses incurred by the parties.

A Simple Example
It is probably helpful to illustrate some of the potential tax issues with a relatively simple example.

Suppose that Company Z brings a lawsuit against Company A for trademark infringement and unfair competition, claiming that certain marks used by Company A infringe on similar registered marks owned by Company Z. Company A asserts that there is no infringement, and also argues that the marks owned by Company Z are invalid. After some litigation, the parties sign a settlement agreement to resolve the dispute. As part of the settlement agreement, Company A agrees to acquire the registered marks owned by Company Z and pays Company Z a sum of $10 million. In return, Company Z agrees to transfer its registered marks to Company A, to dismiss the lawsuit and to release all related claims against Company A.

Company A has a couple of alternatives for treating the settlement payment and other legal fees incurred in this trademark litigation. It could treat the total payment as an acquisition of the registered marks owned by Company Z. Costs incurred for the acquisition of an asset, or settlement amounts and other litigation costs incurred to defend or perfect title to an asset, are capitalized, regardless of the primary purpose of the taxpayer in making the payment. (See Woodward v. Comr., 397 U.S. 572 (1970); U.S. v. Hilton Hotels Corp., 397 U.S. 580 (1970). See also Treas. Reg. Sec. 1.263(a)-4(b)(1), (c) and (e).) In this alternative, the total amount would be capitalized and amortized ratably over 15 years under Section 197 of the Internal Revenue Code.

Alternatively, Company A could treat a portion of the total payment as a royalty payment or damages for past infringement, with the balance attributable to the acquisition of the registered marks owned by Company Z. Company A cannot logically treat all of the payment as damages for past infringement, as such a position implies that the infringed IP owned by Company Z has significant value.

Under such an alternative, the portion of the payment allocable to the acquisition would be capitalized and amortized ratably over 15 years. The portion of the payment allocable to damages would be either currently deductible or potentially subject to Section 263A inventory accounting rules as an indirect production cost. (See Treas. Reg. Sec.1.263A-1(e)(3)(ii)(U), Licensing and franchise costs — including fees for contractual right to use a trademark. See also Robinson Knife Manufacturing Co. v. Commissioner, 600 F.3d 121 (2nd Cir 2010), rev'g TC Memo 2009-9 — sales-based royalty payments that are incurred only upon sale of inventory are deductible and not subject to 263A computations. The IRS has non-acquiesced in the Second Circuit's Robinson Knife decision and indicated that it will not follow that holding outside the Second Circuit. See AOD 2011-01, as corrected by Announcement 2011-32.)

If included in inventory under Section 263A, the payment would be effectively expensed as the inventory moves through the cost of goods sold calculation. From a tax perspective, Company A would generally prefer to allocate as much of the settlement payment to the damages portion as possible because such an allocation accelerates the deductibility and lowers the net after-tax cost on a present value basis compared to the first alternative.

The most beneficial alternative or allocation will depend on the facts of the case and the particular way the parties structure the settlement agreement, not on the subjective motivation of Company A for making the payments. If the parties draft the settlement agreement to treat the full amount of the settlement payment as consideration for the transfer of the registered marks owned by Company Z, then it will be very difficult for Company A to argue that a substantial portion of the payment should be treated as deductible damages. In fact, for federal income tax purposes, taxpayers are generally bound by the terms of their legal agreement and cannot take a different tax position absent sufficient evidence to modify or invalidate the actual agreement or strong proof that the parties intended a different arrangement.

For Company Z, if the settlement agreement states that the recovery is for lost profits or lost royalties, it would be taxable as ordinary income. If the settlement treats the payment as a recovery for damage to a capital asset such as goodwill, or to the sale or assignment of the registered marks, then the payment may be tax-free up to the amount of basis in the asset, with any excess treated as capital gain. (The tax basis of a taxpayer in an asset generally represents the amount of money invested in the asset, adjusted for any applicable depreciation or amortization.)

For many plaintiffs, the preferred alternative may be to maximize the amount of tax-free recovery or capital gain realized from the settlement. Such an alternative is especially attractive if the capital gain is subject to a lower tax rate, e.g., if Company Z is classified as a pass-through entity for federal income tax purposes and the capital gain will flow though to individual owners. Even if Company Z is a C corporation and does not qualify for any preferential tax rate on capital gain, a characterization as capital gain may be beneficial if Company Z has capital loss carryovers, which can be used only to offset capital gain.

Alvarez & Marsal Taxand Says:
The above example illustrates the importance of tax planning considerations during the litigation and settlement process. In particular, the settlement agreement drafting process should always include a review by tax professionals. While the characterization and allocation of payments in a settlement agreement may not by itself be binding on the IRS or the courts for tax purposes, such documentation generally carries great weight as the contemporaneous result of arm's-length dealing between two adversarial parties with conflicting interests on business (and often tax) issues. Moreover, as noted, taxpayers are generally bound to follow the terms of their settlement agreements in the tax treatment of any payments received and expenses incurred. Therefore, tax considerations should be addressed during the negotiation and drafting process for the settlement agreement, rather than delegated to post-transaction compliance.

In addition to the settlement process, tax considerations should also be addressed during the litigation phase, especially with respect to the evaluation of damages and legal claims. For example, the IRS has looked at plaintiff valuation reports as a significant factor in the tax treatment of damages received by the plaintiff. (See TAM 2006 25032: "The damages reports prepared by Company A's experts did not assert that Company B's actions had an adverse effect on the value of Company A's copyrighted material or trade secrets. There is no indication that Company B used the infringed material to develop products superior to those of Company A which adversely affected the market for Company A's products subsequent to Company B's sales of its infringing products.") If a plaintiff wants to strengthen and optimize any allocation of the settlement payment as a recovery for damage to a capital asset, it is essential that the evaluation of damages performed by its experts should be presented and analyzed consistently with such a tax position in mind.

Companies involved in IP litigation need to consider tax issues throughout the litigation and settlement process in order to support the maximum net after-tax recovery, or to minimize the net after-tax cost of any payments and expenses. It is too late to wait until after the settlement agreement is signed and the ink is dry to think about the applicable tax considerations.