Convergence of IP and tax law distinguish TEI's comments on cross licensing arrangements: institute also follows up on cost sharing.

Cross licensing arrangements generally involve two parties licensing a group of patents or other intellectual property. In Notice 2006-24, the Internal Revenue Service asked a series of questions on the business use of these arrangements, including the commercial circumstances that prompt the decision for companies to enter into cross licensing arrangements, the terms of the agreements, other agreements to which CLAs might be analogized, the methods by which industry sets values on the rights to CLAs, and the appropriate U.S. federal tax and accounting treatment of CLAs. In comments filed with the IRS in June, TEI responded to those questions.

"The notice is an unusual one," according to TEI's 2005-2006 president Michael P. Boyle. "The IRS presented several theories for treatment of CLAs, but reached no conclusion. We understand that the issue arose in an examination of a taxpayer and subsequent request for technical advice. We commend the IRS for seeking broader information about the issue before reaching a conclusion on the merits."

The Institute president also praised the TEI members and their companies who worked on the Institute's comments. "The information requested by the government required our members to involve their IP departments; the information was not readily available within the tax department," he said. "We are fortunate that we have talented members who can reach outside their area of expertise to address the difficult issues raised in the notice. Their participation will help the government reach an informed decision about CLAs."

Mr. Boyle noted that there is little "official guidance" on the taxation of CLAs. "A private letter ruling from the 1970s permitted the taxpayer to report as income only the net cash transferred in the cross licensing arrangement. Although the reasoning of the ruling is sparse," he stated, "we believe the result is sound." He added that TEI urged the IRS to re-affirm the ruling's conclusion.

TEI's Written Comments on CLAs

In its June 23 comments, the Institute explained that CLAs are typically non-exclusive agreements and parties may enter into CLAs with multiple parties with respect to the same IP. "The exchange of these rights may take many forms, but the licenses have one primary function," TEI said, "to provide each party with the freedom to operate, i.e., the ability to continue one's business without fear of litigation for infringing on another's IP."

CLAs are also used in co-development arrangements where two or more parties make available pre-existing IP to develop a commercially viable product, the Institute said. These arrangements permit parties to share one another's expertise to increase the likelihood, and lower the cost, of developing a marketable product.

Explaining the importance of the agreements to businesses, TEI said they accord CLA participants the freedom to operate without fear of patent infringement litigation, in the case of cross licenses, and access to otherwise unavailable IP, in the case of co-development agreements. "By providing such freedom, the agreements obviate detailed analyses and reviews of prior technology owned or controlled by the other party. CLAs are neither barter exchanges nor revenue-generating licensing transactions as those terms are normally understood in business commerce; rather, they exist to provide a measure of protection and permit companies to design, manufacture, and sell products worldwide in a more efficient manner. The arrangements normally do not involve the transfer of an IP ownership right, which would include a transfer of the right to preclude others from using the IP."

The tax organization next addressed the financial accounting aspects of the agreements. "Under U.S. generally accepted accounting principles (GAAP), revenues and gains can be recognized only if they are both (i) realized or realizable and (ii) earned; revenues and gains are realized when products are exchanged for cash or claims to cash," TEI said. "Revenues and gains are realizable when the assets received are readily convertible to known (or quantifiable) amounts of cash or claims to cash. Under this standard, any revenue (other than cash payments) under a CLA cannot be properly recognized, since the rights conveyed under such agreements cannot be converted to known amounts of cash or claims to cash."

TEI elaborated that recognition of noncash revenue from a CLA is also improper under the special revenue recognition rules for nonmonetary (barter) transactions. "Under these rules, parties must generally recognize gain or loss based on the fair value of the properties exchanged. The rules apply, however, only to 'exchanges,' which by definition occur only if the transferor has no substantial continuing involvement in the transferred asset." Patent CLAs clearly do not transfer all substantial continuing involvement in the portfolios, the Institute concluded.

In discussing the tax rules for these agreements, TEI remarked that gross income requires an accession to wealth, which can occur only when income has been realized, which itself requires that the value be established with certainty. "In the case of CLAs, which are typically equivalent to covenants not to sue," it said, "no realization of income has occurred because the parties generally do not realize any gains, but rather receive only the assurance that they develop their own technology without risk of litigation. In co-development CLAs, no realization event occurs upon entry into the arrangement because one cannot ascertain whether a commercially exploitable product will result, thereby making the amount of any income indeterminable with reasonable accuracy."

Under the withholding tax rules, a withholding obligation is triggered only if the U.S. taxpayer has control over "money or property" belonging to the foreign licensor from which it could withhold and had knowledge of the facts giving rise to the payment. "In a CLA with no monetary payments," TEI contended, "there is no money or property of the foreign licensor that is in the custody or control of the U.S. taxpayer. Such arrangements are similar to cancellation of a debt, which does not trigger a withholding obligation because of the lack of custody or control over money or property." The organization concluded that this treatment is also consistent with the tax treatment of CLAs in foreign jurisdictions.

TEI explained that imposing tax on phantom "payments" under a CLA could significantly inhibit research and development projects." Because no other country imposes a withholding obligation in respect of these arrangements, "U.S.-based taxpayers would also suffer a competitive disadvantage vis-a-vis their foreign counterparts. Thus, the U.S. party would undoubtedly bear the additional cost of the tax."

The Institute concluded that unrelated parties involved in cross licensing arrangements are in the best position to determine that such arrangements do not represent an exchange of value. It urged the IRS to affirm its long-standing practice of not imputing income to parties that participate in such agreements.

TEI's comments are reprinted in this issue, beginning on page 312.

Cost Sharing Regulations

TEI members and staff met in August with Treasury's International Tax Counsel Hal Hicks and IRS Associate Chief Counsel (International) Steven Musher to discuss the Institute's comments on the proposed cost sharing regulations. Led by TEI International Tax Committee chair Janice Lucchesi of Akzo Nobel Inc., the Institute's delegation to the August 4, 2006, meeting included TEI Executive Committee member Paul O'Connor of Millipore Corporation and International Tax Committee member Dorothy Chao of Baxter International Inc., together with Eli Dicker and Mary Lou Fahey of the Institute's legal staff.

The meeting followed up on an invitation from the Treasury Department during TEI's liaison meetings earlier this year. The Treasury official asked the Institute to assist in making the proposed regulations more administrable. What four or five or six changes can we make, he asked, to make the rules more workable?

The Institute's delegation focused on the need for more flexibility in the regulations, highlighting the regulations' investor model and its use of the weighted average cost of capital and the infinite nature of the buy-in payments. The group also discussed other aspects of the proposal including the transition and administrative rules.

Revised regulations are not expected to be released until after the end of the year. TEI's November 28, 2005, comments on the regulations are reprinted in the November-December 2005 issue of The Tax Executive.