TEI comments on Notice 2006-34: cross licensing arrangements.

On March 15, 2006, the Internal Revenue Service issued Notice 2006-34, relating to the taxation of cross licensing arrangements (CLAs). The Notice asks several questions concerning the business use of such arrangements and requests comments. The Notice was published in the April 3, 2006, issue of the Internal Revenue Bulletin (2006-14 I.R.B. 705).

Background

Tax Executives Institute is the preeminent association of business tax executives in North America. Our more than 6,000 members represent 2,800 of the leading corporations in the United States, Canada, Europe, and Asia. TEI represents a cross-section of the business community, and is dedicated to developing and effectively implementing sound tax policy, to promoting the uniform and equitable enforcement of the tax laws, and to reducing the cost and burden of administration and compliance to the benefit of taxpayers and government alike. As a professional association, TEI is firmly committed to maintaining a tax system that works--one that is administrable and with which taxpayers can comply in a cost-efficient manner.

Members of TEI are responsible for managing the tax affairs of their companies and must contend daily with the provisions of the tax law relating to the operation of business enterprises. We believe that the diversity and professional training of our members enable us to bring a balanced and practical perspective to the questions asked by Notice 2006-34, which requests information on a broad range of issues, 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. (1)

Executive Summary

Cross licensing arrangements generally involve two parties licensing a group of patents or other intellectual property (IP). 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: 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. These arrangements permit parties to share one another's expertise to increase the likelihood, and lower the cost, of developing a marketable product.

These agreements are important because they give 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.

Often these CLAs will not involve cash payments between the parties. In some cases, however, a royalty is paid based on one another's negotiated agreement. The parties do not, however, need to agree about the fair market value of the respective technologies; rather, they need only reach an agreement on the amount of any cash payment. Appraisals are not normally conducted; the amount of the fee, if any, is an amount agreed upon by the parties as a result of their arm's-length negotiations reflecting the relative bargaining power of each party. Any payment due from one party to the other does not address the respective values of each party's IP.

Significantly, the parties do not normally recognize revenue from these agreements for financial accounting purposes. 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. 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.

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. (2)

Under the tax rules, 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, 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, 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. This treatment is also consistent with the tax treatment of CLAs in foreign jurisdictions.

Under a CLA, income tax is properly imposed on any actual cash payments made pursuant to the CLA. TEI understands, however, that the IRS is considering whether income tax may be imposed upon the imputed fair market value of the IP rights subject to a CLA, treating any cash payment as a "net amount" reflecting the purported difference in the imputed fair market value of the IP owned by each party. Regrettably, imposing tax on these phantom "payments" under a CLA could significantly inhibit research and development projects as companies forgo CLAs because of valuation difficulties. (Because these agreements are not valued for IP purposes, the tax valuation--outside the normal negotiation process--would take place in a vacuum.) Moreover, because, we believe, 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. Finally, because imputed amounts under CLAs are not reflected in a company's financial accounting records, requiring taxpayers to determine a fair market value and recognize imputed amounts as income or expense for tax purposes would create a heavy (and unjustified) compliance burden.

In sum, the unrelated parties involved in cross licensing arrangements are in the best position to determine that such arrangements do not represent an exchange of value. The IRS should affirm its longstanding practice of not imputing income to parties that participate in such agreements.

The Value of Cross Licensing Arrangements for Business

Addressing the questions raised by Notice 2006-34 requires an understanding of how intellectual property is developed and why many enterprises choose to enter into cross licensing arrangements in order to help manage and exploit their own IP. These agreements are not entered into for tax purposes, but rather to permit the parties to operate in a climate free from the very real threat of patent infringement litigation. The need for cross licenses stems, in part, from the rights conferred in a patent and the value of patents in a technology-oriented society. The most notable of the rights conferred in a patent is the right to exclude others (through the use of a court injunction or otherwise) from the use of the patented innovation. As technology-based products and their components have grown, the number of suits asserting patent infringement has also grown.

The development of new innovative products requires knowledge of and reliance on prior innovation, thereby increasing the likelihood of so-called blocking patents or patents that are at least commercially desirable to incorporate into future products. Moreover, the increasingly multifaceted nature of technology products contributes to the likelihood of competing and complementary patent interests. Thus, a company may need access to multiple patents in order to create a single, useful product. Often, a company obtains rights to the prior technologies to better manage the risk of patent infringement claims.

Also known as a reciprocal license, CLAs generally involve two (or more) parties nonexclusively licensing a group of patents or other intellectual property (usually a portion of the total portfolios, known as a "field of use"). The agreement may be in the form of (i) licenses granted to manufacture, sell, use, or dispose of products, or (ii) an exchange of covenants not to sue each other (including, in some cases, each other's customers) in the defined field of use. The license or covenant provides the other party with a measure of freedom to operate, i.e., the ability to continue one's business without fear of litigation based upon a claim of patent infringement. Under patent law, licenses generally include exhaustion of the licensed patents ("patent exhaustion") to protect the licensee's customers from the same patent risks, (3) whereas covenants not to sue generally are granted to a specific party and, unless specified otherwise, have no downstream effects. In each case, however, equivalent results can be achieved.

For example, an enterprise may find that its efforts to create a single, useful product may implicate claims made in multiple patents held by its competitors; the competitors likewise may find that their efforts to make their own competitive products implicate claims made in the patents held by the enterprise. In such cases, the enterprise and its competitors may enter into CLAs to avoid the risks of costly, uncertain, and potentially debilitating patent litigation. In this context, CLAs do not involve the transfer of ownership in the IP, which would include a transfer of the right to exclude others from using the IP--substantially more than just the right not to be sued. As previously explained, CLAs are typically non-exclusive agreements and parties may, and often do, enter into CLAs with multiple parties with respect to the same IP.

CLAs are also used in co-development arrangements pursuant to which two or more parties make available to one another their extant IP to develop a commercially viable product. These arrangements are often employed, for example, in the pharmaceutical industry, permitting parties to share one another's expertise to increase the likelihood, and lower the cost, of developing a marketable drug. During development, the parties may grant each other rights to their IP, limited to the conduct of the co-development activity. On a going-forward basis, each party may need a license to the others' IP to allow each party to commercialize any new products developed as a result of the collaboration. The cross license needed for commercialization may be on different terms from the one needed for the co-development activity.

By providing taxpayers the freedom to operate without fear of patent infringement litigation (in the case of cross licenses) and the access to otherwise unavailable IP (in the case of co-development agreements), CLAs obviate detailed analyses and reviews of prior technology owned or controlled by the licensee. A decision to tax these phantom "payments" between parties to a CLA would spawn valuation difficulties in respect of the cross licenses and likely inhibit research and development projects. Fewer CLAs could engender more patent litigation, deeper review of prior technology, and greater scientific efforts to work around existing patents rather than focusing on providing advanced, cost-effective features, functionality, and benefits to the consumer. Because no other country imposes a withholding obligation (or income taxes) in respect of these arrangements, U.S.-based taxpayers would also suffer a competitive disadvantage vis-a-vis their foreign counterparts if CLAs give rise to a taxable event. Indeed, imposing such an obligation would be directly contrary to the U.S. Department of Treasury's policy of increasing the competitiveness of U.S. companies in the world economy.

Even assuming that the agreements transfer something valuable, the value of the transferred rights would not be easily ascertainable. Indeed, TEI is concerned that taxing cross licenses would be unduly burdensome and unadministrable because no business need exists to determine the respective value of each party's licensed patents. Valuing CLAs for tax purposes would be done in a vacuum outside the normal negotiation process. Moreover, because imputed amounts under CLAs are not reflected in a company's financial accounting records, requiring taxpayers to value and recognize these amounts as income or expense for tax purposes will create an extraordinary compliance burden. (The starting point for preparing corporate tax returns is a company's financial accounting records; when items do not exist for financial accounting purposes, there is nothing to adjust for tax purposes.) Finally, collecting withholding tax on the deemed income may prove unfeasible because there are normally no funds on which to withhold.

The Use of CLAs

1. Covenants Not To Sue. The use of CLAs may differ from industry to industry, but in many cases they are used when the company must adhere to certain industry standards or applications. In the bulk of these agreements, what particular technology is owned by each party may be unknown and values are not ascertainable. The parties are generally seeking to develop their own product without fear of infringing another's IP. (Cash, if transferred, is transmitted only to the party having greater perceived bargaining power.) Often the agreement will include IP that has yet to be developed, but may arise over the life of the CLA. (4)

Many technology-based products are extremely complex, and it is difficult for a company to operate without concern that it may infringe on another company's patents. This is particularly true when all the companies must adhere to some acceptable technology standard, while holding hundreds or thousands of patents and continually developing new technology. Standards-setting bodies typically require that participants license certain patents--which the participant declares to be essential to the standards adopted by the body--to others before including the technology in the standard. (5) If a company does not agree, the standards-setting body undertakes to "design around" those essential patents. Companies in these standards-setting industries (such as semiconductors and telecommunications) frequently implement cross licenses because the parties desire freedom of action with respect to equipment that complies with the particular standard. (6)

In this context, CLAs are usually limited to patents and do not include the transfer of other technology, such as know-how, instruction, or supervision. One party often may not own or control any patents of interest to the other party; in such a case, the cross license simply ensures immunity from patent infringement litigation in the event that there are any unknown patents in the cross-licensor's portfolio or the cross-licensor develops a new invention that may apply to the products related to the CLA. It is also conceivable that the cross-licensor may prospectively contribute to an update or revision of the standard that incorporates essential patents.

In other words, a CLA often involves only a covenant not to sue for "passive" use of the licensed patent by the licensee. Hence, the only benefit from CLAs is the freedom to operate without review and analysis of the other party's patent portfolio.

Although the language of a CLA may refer to rights to "make, have made, import, sell, lease, use, or otherwise dispose of" licensed equipment for use in licensed applications, this is standard language used by IP lawyers to ensure patent exhaustion when that is the desired outcome. Notwithstanding this language, the parties may be unable to actually use the technology implementing the other party's patents if a CLA does not include any transfer of the know-how necessary to successfully exploit the technology embodied in the underlying patents. (7)

2. Co-Development Agreements. In some cases, such as in the pharmaceutical industry, unrelated parties may share resources to co-develop a product pursuant to a cross license. For example, an established drug company may collaborate with a specialized bio-technology company with a promising portfolio of target molecules. Under such an arrangement, each will grant the other a non-exclusive right to use each other's preexisting IP, both patented and unpatented, within the field of use. Such arrangements may provide that each party will share in an agreed portion of the costs of development. (8)

Any IP developed under the co-development agreement may be jointly or exclusively owned. (9) For example, the IP may be divided exclusively based on functions (manufacture versus distribution), field of use, or territoriality. The parties grant each other rights to use each other's extant IP and the IP developed pursuant to the co-development arrangement to sell any new products arising from the arrangement. (10) In some cases, the parties may enter into a co-development arrangement without entering into a written license allowing each other access to existing IP. This is done because some companies believe it is impossible to restrict the use of each other's IP to the field of use of the co-development agreement.

A party may agree to make milestone payments to the other party at the beginning and during the course of development pursuant to the co-development arrangement. These payments may properly be considered access fees, i.e., the price to enter into the agreement and access existing IP, if any.

The parties do not provide for royalties for the use of the IP during the course of development because they will not know whether there will be developed IP until a target reaches the commercial stage. At that point, the parties will not need to pay each other royalties if the resulting IP is jointly owned and the parties jointly commercialize the IP. Otherwise, in the case of exclusive exploitation rights, the parties may charge royalties for the portion of the IP that each is individually exploiting. For example, while many arrangements are possible, one party may owe the other a royalty upon the sale of products embodying the newly developed IP. (11)

Valuation of CLAs

To TEI's knowledge, CLAs involving covenants not to sue are not valued through the use of financial analysis of the underlying individual patents themselves. Any such analysis of the potentially large numbers of such patents would require significant resources and would have to take into account many factors (e.g., any established market value of the patent, contribution of the patent to the anticipated product, value of comparable inventions, price and profit margins of the product using the patented technology). (12) Given the complexity of the task and the absence of significant business purpose, parties to CLAs do not engage in such theoretical analyses.

Moreover, it is TEI's understanding that the majority of CLAs do not involve cash payments between the parties. The licenses are sought more to manage the nuisance value of any potential litigation rather than to effect a true exchange of IP. In the relatively small number of cases where a cash payment is used, the amount of the fee is based on the parties' relative negotiating positions; it is not an amount based upon a valuation of their separate patent rights and settlement of a "net" difference in cash.

The process thus differs significantly from that used to value cross-border transactions pursuant to section 482 of the Code (e.g., through a transfer-pricing study). CLA cash payments are not determined by outside experts using theoretical valuation methodologies. Indeed, in some cases, the agreements expressly provide that any amount paid between the parties is no reflection of the fair market value of the IP subject to the license.

Consider the following example where a cash payment is made: Company A and Company B each have a portfolio of patents and enter into a CLA providing mutual covenants not to sue each other. As part of the negotiations, Company A agrees to pay Company B an upfront payment of $10 million. It is possible that this cash payment could be the result of each party believing that Company B's patents are worth $50 million and Company A's patents are worth $40 million. The same value could, however, be reached by each party believing that Company A's patents are worth $1 million and Company B's are worth $11 million. Furthermore, the cash payment might simply be the result of Company B having more bargaining power than Company A, without regard to the actual or perceived values of the respective patent portfolios (i.e., the relative nuisance value of any potential suit). Therefore, taxing these transactions based on anything other than the cash amount that one party pays the other would involve a complex and theoretical valuation exercise that neither party has otherwise undertaken. (13)

Although the need to engage in valuation exercises, particularly in respect of related-party transactions, is an unavoidable aspect of tax law, the valuation of intellectual property is almost certainly the single most difficult valuation task undertaken by taxpayers. Appraisers acting in good faith can produce enormously different values simply by selecting what otherwise would appear to be discount rates or growth projections that differ only slightly from each other. In addition, the value of the cross license may be different for each party. Sound tax administration should be reluctant to interject academic valuation exercises--where there is no exchange of property--into transactions negotiated by unrelated parties.

The same analysis holds true for co-development agreements. The parties do not normally conduct appraisals of the licensed IP to determine if one party owes the other a payment. Instead, they negotiate based on the perceived value of the IP being licensed as well as the value of the party's participation in the arrangement. The payment due from one party to the other does not address the separate values of each party's IP.

Finally, another difficulty to valuation relates to the non-exclusive nature of CLAs entered into to obtain freedom to operate. The imputation of phantom income and expense with respect to such CLAs would lead to absurd results in the case of taxpayers that enter into multiple CLAs in highly competitive industries. For example, consider an enterprise that enters into a CLA with a competitor with respect to patents related to products that each company sells and the IRS imposes tax based on imputed income and expense purportedly arising under the CLA. The enterprise then enters into a CLA with an additional nine competitors. Must the taxpayer recognize income and expense an additional nine times? The imposition of tax upon phantom payments will lead to enormous compliance expenses, as well as capricious and bizarre tax results.

Financial Accounting Treatment

Section 446(a) and (b) of the Internal Revenue Code provide that taxable income shall be computed under the method of accounting on the basis of which the taxpayer regularly computes its income in keeping its books unless that method does not clearly reflect income. Recording any sort of revenue for the CLA transactions described above generally conflicts with how the books are kept and with U.S. generally accepted accounting principles (GAAP).

Under U.S. GAAP revenue recognition principles, revenues and gains can be recognized only if they are both (i) realized or realizable and (ii) earned. See, e.g., Statement of Financial Accounting Concepts (SFAC) No. 5, Recognition and Measurement in Financial Statements of Business Enterprises [paragraph] 83. For purposes of the first part of the test, "[r]evenues and gains are realized when products (goods or services), merchandise, or other assets are exchanged for cash or claims to cash. Revenues and gains are realizable when related assets received or held are readily convertible to known amounts of cash or claims to cash." Id. at [paragraph] 83a. Under this concept statement, no revenue (other than cash payments) should be recognized under a CLA because the rights granted under such agreements cannot be converted to known amounts of cash or claims to cash.

Moreover, the parties to CLAs cannot properly recognize noncash revenue under the special revenue recognition rules for non-monetary (barter) transactions in APB Opinion No. 29 (APB 29), Accounting for Non-monetary Transactions, as amended by SFAS No. 153, Exchanges of Nonmonetary Assets. Under these rules, parties to nonmonetary transactions must generally recognize gain or loss based on the fair value of the properties exchanged. The rules apply, however, only to "exchanges." As explained in SFAS No. 153, "[a] reciprocal transfer of a nonmonetary asset shall be deemed an exchange only if the transferor has no substantial continuing involvement in the transferred asset such that the usual risks and rewards of ownership of the asset are transferred." Because licensors of patent CLAs retain substantial continuing involvement in the subject portfolios, the transactions do not fall under the SFAS No. 153 definition of an exchange. Moreover, even if a CLA were accounted for as a "nonmonetary exchange" under APB 29 and SFAS No. 153, two separate exceptions to the general rule would apply to prevent requiring recognition of gain or loss on the fair value of the properties exchanged. Under these exceptions, gain or loss would be recognized on the recorded value of the properties exchanged, which would be zero in the case of internally developed internal assets since R&D is expensed, rather than capitalized, under GAAP.

SFAS No. 153 provides an exception to fair value recognition where "[t]he fair value of neither the asset(s) received nor the asset(s) relinquished is determinable within reasonable limits." SFAS No. 153, [paragraph] 20a. SFAS No. 153 provides a further exception to fair value recognition for transactions that lack commercial substance. SFAS No. 153, [paragraph] 20c. For this purpose, "[a] non-monetary exchange has commercial substance if the entity's future cash flows are expected to significantly change as a result of the exchange." SFAS No. 153, [paragraph] 21 (Emphasis added). CLAs between companies that are used as reciprocal agreements not to assert patent infringement claims are used to mitigate litigation risks and do not represent exchanges of commercial substance, as defined in SFAS No. 153, because the effect on future cash flows of these agreements is tenuous, at best. Therefore, a company's recognition of revenue under GAAP for CLAs of this nature would be improper and falsely represent income in a company's financial statements. (14) Further, even if a company concludes that a particular CLA represents an exchange of commercial substance and is subject to APB 29, the company often does not recognize revenue because the fair value of the cross license is not determinable. See SFAS No. 153, [paragraph] 20a.

In short, in these circumstances U.S. GAAP does not require (or even permit) the recognition of noncash income under the patent CLAs that represent mere covenants not to sue. While financial accounting is not controlling for tax purposes, see, e.g., Thor Power Tool v. Commissioner, 439 U.S. 522 (1979), it is highly relevant, particularly in this instance where no tax rule provides that CLAs must be treated differently for tax purposes.

As provided in Treas. Reg. [section] 1.446-1(a)(1), "[e]xcept for deviations permitted or required by such special accounting treatment, taxable income shall be computed under the method of accounting on the basis of which the taxpayer regularly computes his income in keeping his books" (emphasis added). While the tax law requires that particular items recorded in a taxpayer's accounting records be treated differently (e.g., in terms of deductibility, timing of recognition, method of depreciation and amortization, etc.) for tax purposes, accounting records remain the starting point for computing taxable income, see Treas. Reg. [section] 1.446-1(a)(4), and taxpayers are required to reconcile financial statement net income or loss with taxable income reported on Form 1120 on an item-by-item basis on Schedules M-1 and M-3. Taxpayers have no basis, however, to adjust these schedules for "phantom" noncash items of indeterminable value that do not exist from a financial accounting standpoint.

Similarly, co-development CLAs do not meet the accounting standard under SFAS No. 153 for recording revenues based on an imputed amount of royalties. First, there is no exchange because the licensees have not transferred the risks and rewards of the licensed IP and, in fact, have continuing involvement. Second, these CLAs are generally high-risk arrangements and the probability of success is often uncertain. Assigning a value to the transferred IP would be impossible at worst and highly speculative at best.

Foreign Tax Treatment

TEI is aware of no foreign country that taxes the use of cross licensing arrangements. If the United States imposed withholding tax on phantom income deemed paid to a foreign licensor (which bears the tax), the foreign licensor would presumably seek foreign tax credit relief for the U.S. taxes paid, leading to competent authority claims that could clog an already slow system. Assuming competent authority did not eliminate the U.S. withholding tax, foreign countries may well impose withholding tax on the reciprocal income deemed paid to the U.S. entity--resulting in a zero-sum game. Imposing withholding tax on the deemed outbound payment and permitting a foreign tax credit on the deemed inbound payment would result in higher administrative burdens on taxpayers and governments alike, ultimately without any net benefit to the U.S. fisc. (15)

Alternatively, if a foreign country does not assert a reciprocal tax and the liability falls on the U.S. taxpayer, there would be a negative economic and anti-competitive effect on the U.S. entity. The U.S. taxpayer may also be required to indemnify the foreign party for the withholding tax.

Tax Consequences of CLAs

1. Realization of Income. In Private Letter Ruling 7739073 (July 1, 1977), the IRS considered the effect of a cross licensing arrangement between U.S. and Japanese companies granting irrevocable, nonexclusive licenses for patents. In addition to the transfer of cross licenses, the Japanese company agreed to pay the U.S. taxpayer a lump sum of cash (46X). To take advantage of a Japanese law on the sale of technical exports, the parties entered into a second agreement under which the Japanese company would sell to the U.S. taxpayer for a lump sum of 35X dollars an undivided one-third interest in three of the U.S. patents that had already been sold to the taxpayer under the first agreement. The ruling notes that--

   In substance the transactions amount
   to a cross license agreement under
   which the only taxable payment under
   U.S. law is a net lump sum payment
   to the taxpayer of 11X dollars,
   this figure arrived at by netting the
   payment due under Agreement 1
   (46X) with the cost to the taxpayer of
   obtaining the worthless patent rights
   under Agreement 2 (35X).

Thus, the ruling treats the CLA as a netting arrangement that does not result in the recognition of income except to the extent of a cash payment, if any, between the parties. Although the rationale in the ruling is sparse, TEI believes that it reaches the correct result. It is also consistent with the approach taken in the cost-sharing regulations, where participants making buy-in payments are permitted to recognize income only to the extent of cash payments made under Treas. Reg. [section] 1.482-7(g)(2).

The treatment of cross licenses raises fundamental threshold questions concerning what is income and when is it realized. Under section 61(a) of the Code, gross income means all income from whatever source derived. Treas. Reg. [section] 1.61-1(a) provides that gross income includes income realized in any form, whether in money, property, or services. In short, gross income requires an accession to wealth. Commissioner v. Glenshaw Glass Co., 348 U.S. 426, 431 (1955) (exemplary and punitive damages are "undeniable accessions to wealth, clearly realized, and over which the taxpayers have complete dominion"). An accession to wealth occurs only when it has been clearly realized. Eisner v. Macomber, 252 U.S. 189, 212 (1920); see also P.L.R. 9814030 (April 3, 1998) (remediation services transferred in return for agreement not to sue parties responsible for contamination is not an income realization event).

There is a practical accounting aspect to the realization concept. For accounting and valuation purposes, the increase or decrease in a taxpayer's net worth (i.e., the value of its assets) will not be "realized" until there is some "event that freezes or fixes the gain with sufficient certainty so that it is proper to tax it." Lowndes, Current Conception of Taxable Income, 25 Ohio St. L J. 151, 173, (1964), quoted in Bittker & Lokken, Federal Taxation of Income, Estates, and Gifts [paragraph] 5.1 n 28 (emphasis added)).

In the case of covenants not to sue, no realization of income occurs because the parties have not realized any gains, but rather receive only the peace of mind to develop their own technology. See Old Colony Trust Co. v. United States, 15 F. Supp. 417 (D. Mass 1936) (mutual release signed by cross litigants created no income to estate when estate recovered nothing in settlement and was diligent in the prosecution of the claim); Sobel, Inc. v. Commissioner, 40 B.T.A. 1263 (1939) (where litigation is bona fide, mutual release did not give rise to cancellation of indebtedness income); In re Turner, 70 A.F.T.R. 2d 92-6069 (Bankr. D.Wyo. 1992) (mutual release had no value to buyer; behavior of parties indicated that no value was allocated to liability release).

In co-development CLAs, no realization event occurs upon entry into the co-development arrangement because it is not possible to ascertain whether a commercially exploitable product will result from the joint development under the arrangement. Thus, the amount of income (if any) that will result from such exploitation cannot be determined with reasonable accuracy. See Treas. Reg. [section] 1.451-1(a) ("Under an accrual method of accounting, income is includible in gross income when all the events have occurred which fix the right to receive such income and the amount thereof can be determined with reasonable accuracy."). Once a commercially viable product is developed, income is realized in the form of profits from sales of the product embodying the developed IP or from royalties that a party might be entitled to from the other party to the co-development, depending upon the agreement of the parties. But there is no imputed income arising from a theoretical valuation of the rights granted pursuant to the CLA; the realization event does not occur until a commercially viable product is developed and sold.

In both covenants-not-to-sue CLAs and co-development CLAs, no independent value is created and no event occurs to allow the transactions to be valued with sufficient certainty to trigger realization. Treating these agreements as lacking in sufficient substance to warrant taxation is also consistent with their treatment for financial accounting purposes.

3. Withholding Tax under Section 1441. Treas. Reg. [section] 1.1441-2(d)(1) provides that a payment (whether actual or deemed) of U.S. source gross royalty income by a U.S. taxpayer to a foreign licensor may trigger U.S. withholding tax only if the U.S. taxpayer had custody or control over "money or property" belonging to the foreign licensor from which it could withhold and had knowledge of the facts that gave rise to the payment. This regulation emphasizes that the foreign licensor has the obligation for the tax and the U.S. taxpayer is merely a withholding agent using the foreign licensor's assets to satisfy the obligation. In a cross licensing agreement with no monetary payments, there is no money or property of the foreign licensor that is in the custody or control of the U.S. taxpayer. Subject to the exceptions discussed below, the U.S. taxpayer should not be obligated to use its own funds to satisfy the foreign licensor's obligation. Similarly, if there were a payment of money to the U.S. taxpayer from the foreign licensor, there would be no money or property of the foreign licensor under the custody or control of the U.S. taxpayer from which to withhold. In this instance, the amount received is the U.S. taxpayer's money.

Treas. Reg. [section] 1.1441-2(d)(2) provides cancellation of debt as an example of a deemed payment that is not subject to withholding because of the lack of custody or control over money or property. The provision was added to the regulations in response to concerns expressed about the difficulties in withholding on amounts of income "not represented by cash or property (i.e., deemed payments of income)." T.D. 8734, Withholding of Tax on Nonresident Aliens and Foreign Corporations (Oct. 6, 1997). Thus, this change suggests that withholding should not be required in respect of deemed payments not represented by cash or property. CLAs--with no transfer of cash--should be similarly treated.

Treas. Reg. [section] 1.1441-2(d)(1) provides that there are only three circumstances where the money or property exception will not apply: related party payments, distributions with respect to stock and pre-arranged plans to avoid withholding. The cross licenses discussed in this submission are those between unrelated parties and typically would not involve distributions in relation to stock. With regard to the third requirement, CLAs have not traditionally been subject to withholding payments unless cash payments are made. Parties to a CLA thus have not engaged in a "prearranged plan" to avoid withholding tax because they had no reason to believe the obligation existed or had been asserted by the government. This treatment is also consistent with the tax treatment of CLAs in foreign jurisdictions.

Conclusion

Tax Executives Institute appreciates this opportunity to present its views on the taxation of cross licensing arrangements and their importance to the business community. If you have any questions, please do not hesitate to call Janice L. Lucchesi, chair of TEI's International Tax Committee, at 312.544.7023, or Mary L. Fahey of the Institute's professional staff at 202.638.5601.

(1.) The examples of cross licensing arrangements discussed in these comments are not exhaustive, but rather represent the experiences of TEI members participating in the development of these comments.

(2.) Even if a CLA were accounted for as a "non-monetary exchange," it would fall under two separate exceptions that require that gain or loss be recognized based on the recorded value (which is zero for internally developed assets) and not the fair value if: (i) the fair value is not reasonably determinable, or (ii) the transaction lacks commercial substance because the entity's future cash flows are not expected to significantly change because of the transaction. Therefore, a company's recognition of revenue under GAAP for CLAs is improper and inaccurately represents income in a company's financial statements.

(3.) The doctrine of "patent exhaustion" generally holds that an unrestricted, authorized sale of a patented article "exhausts" the patentee's right to control the further use or sale of that particular patented article. See, e.g., Jazz Photo Corp. v. International Trade Comm'n, 264 F.3d 1094, 1105 (Fed. Cir. 2001).

(4.) The valuation questions posed by IP that has not yet been developed would be particularly daunting.

(5.) These bodies include the European Telecommunications Standards Institute (ETSI), the Institute of Electrical and Electronics Engineers (IEEE), the International Telecommunications Union (ITU), and the Communications and Information Technology Association (CITA).

(6.) Thus, when a party declares that it owns or controls patents that are essential or useful to the relevant standard, the cross license provides the company freedom to manufacture and sell its products in compliance with the standard and, in most cases, provides the company and its customers freedom to use such products without risk of a patent infringement assertion by the cross-licensor.

(7.) A variance of a CLA often in standard license agreements is a "grant back" provision, which conveys to the licensor rights on any improvement to the licensed technology made by a licensee. Such grant backs ensure that any resulting improvements do not hinder the licensor's associated rights, enabling both the licensor and other licensees to utilize the improvements in the applicable field without unacceptable risk. No underlying technology or know-how, however, is transferred pursuant to such a provision. Determining that a useful improvement has been created is so speculative that no value can be attributed to the grant-back provision by the parties at the time the agreement is executed.

(8.) In some cases, one party may agree to pay the entire cost of development. In such cases, the principal provides the funding and grants a license to another party that is doing contract research for the principal. These cases do not involve a true cross license.

(9.) Some licensing agreements may provide that one party obtains exclusive rights within a certain field of use and the other party obtains exclusive rights outside that field. The agreements may also include a covenant not to sue.

(10.) Co-development agreements may be used in other industries and generally include cross licenses of existing patented technology and other know-how.

(11.) Parties are free to structure their collaborative research activities in any manner they choose. Although some taxpayers may enter into joint ventures in which they carry on a business for joint profit as co-owners and thus create an entity taxable pursuant to Subchapter K, others simply agree to collaborate in the development of new products that each sells on its own behalf, with no intention to profit jointly as co-owners of a business. The latter co-development arrangements do not result in the creation of an entity taxable pursuant to Subchapter K. See, e.g., Treas. Reg. [section] 301.7701-1(a)(2) ("A joint venture or other contractual arrangement may create a separate entity for federal tax purposes if the participants carry on a trade, business, financial operation, or venture and divide the profits therefrom ... Nevertheless, a joint undertaking merely to share expenses does not create a separate entity for federal tax purposes.").

(12.) The criteria used in determining the value of the patent have been established through U.S. case law.

(13.) Indeed, as we have already noted, in most plain vanilla CLAs there is no transfer of cash.

(14.) See In re Global Crossing, 313 F. Supp. 2d 189 (S.D.N.Y. 2003) (accounting for reciprocal "swaps" transactions as revenue viewed as "illusory income" in violation of APB 29).

(15.) Treaties may also exempt payments for the use of patents from withholding tax. See, e.g., United States-Canada Income Tax Convention, Art. XII, [section] 3.