Treasury and IRS provide guidance on cross licensing arrangements, permit use of net consideration method.

On February 15, 2007, the U.S. Department of the Treasury and Internal Revenue Service issued Rev. Proc. 2007-23, (1) settling a controversial issue by permitting taxpayers to change to, or continue their use of, the "Net Consideration Method" with respect to qualified patent cross licensing arrangements (QPCLA). The revenue procedure is welcomed relief for the multinational business community, which had expressed great concern about the potential treatment of cross licensing arrangements. The procedure provides guidance that generally validates the tax treatment asserted by the tax adviser and tax executive communities concerning these arrangements notably that--

(i) only the cash payments made with respect to these arrangements should result in withholding tax or tax accounting consequences, and

(ii) the in-kind exchange of intellectual property (IP) rights should have no tax consequences.

Background

Cross-licensing arrangements (CLAs) are common where parties to a prospective licensing agreement have patent rights that the other party wants, or where there is a cluster of patents in a field in which no individual holder of patents can be certain of not infringing on another's patent rights. By entering into a cross-licensing arrangement, each patent holder may operate without fear of being charged with infringement of the rights of the other and operate without the threat of litigation. Depending on the relative value of patent rights, the exchange of a license and cross-license may be accomplished with or without an actual cash payment. (2)

By June 2005, conversations in the tax community and comments by senior government officials on the tax seminar circuit prompted industry groups to express concerns over the potential tax treatment of CLAs. Letters to the Treasury Department from industry and professional associations, together with letters from members of Congress, stressed the importance of these arrangements to the business community and US competitiveness. (3)

Notice 2006-34: Raising Controversy over Potential Taxation

In March 2006, the Treasury Department and IRS issued Notice 2006-34, (4) requesting information across a broad range of issues, including the commercial circumstances that underpin the decision for companies to enter into CLAs, the scope and limitations of CLAs, 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 treatment and consequences of CLAs.

The notice also posited three theories by which CLAs may be characterized and briefly discussed the significant tax consequences that may flow from each characterization. The consequences identified in the notice included tax accounting income and deductions, and withholding, under the U.S. statutory regime for taxing foreign persons on certain items of U.S. source income, on cash payments along with the full value of intellectual property rights transferred to a foreign person under a CLA. (5) In response to the notice's request for comments, several groups submitted letters, including Tax Executives Institute (TEI), other industry groups, and a group of CEOs from nine major technology companies. (6)

Industry Responds to Notice 2006-34

The comments all vigorously argued that it would be contrary to existing law, as well as sound U.S. tax policy and administration, to impose an income tax on the imputed fair market value of the IP rights subject to a CLA. Treating the entire amount of those rights as taxable income--and potentially subjecting it to a U.S. withholding tax where the counterparty is a foreign person--could inhibit research and development and subject U.S.-based taxpayers to a competitive disadvantage, because no other country subjects a CLA to a withholding obligation. Finally, the commentary asserted that income realization on the in-kind amount for tax purposes would require an enormous undertaking by taxpayers to value the imputed amounts and result in extensive compliance burdens, along with valuation disputes with the IRS. To support these assertions, the comment letters generally argued the following points: (7)

1. Cross licensing arrangements are important elements of business strategy because they give the business participants the "freedom to operate" without fear of patent infringement litigation, thereby obviating detailed analysis and reviews of prior technology owned or controlled by a counterparty to a CLA.

2. A CLA is neither a barter exchange nor a licensing transaction for revenue generation, but rather is to provide protection against expensive litigation and allow research and development, manufacturing, and sales to proceed in a more efficient manner.

3. Although a CLA may require one party to make a payment to the other, the parties do not need to agree on the fair market value of their respective technologies.

4. Very important, except to the extent of a cash payment received, parties do not normally recognize revenue from a cross licensing arrangement for financial accounting purposes.

5. A CLA is typically non-exclusive.

For all these reasons, commentators urged that only cash received under a CLA be subject to withholding or tax accounting consequences.

Guidance Acknowledges Industry Concerns and Administrative Challenges

Rev. Proc. 2007-23 summarizes the various comments from industry groups and acknowledges that the "unique interaction of patent and tax law" regarding QPCLAs raises many difficult issues for both taxpayers and the IRS, including significant "administrative challenges" for the taxation of QPCLAs. The procedure notes the drastic increase in the number of patents granted over the last 50 years. (8) It also notes that, while valuation of intellectual property is always difficult, valuation of patent rights is exceedingly difficult where the parties enter into the CLA to avoid or settle patent infringement disputes. Moreover, the Treasury and IRS acknowledge that it would be difficult to trace the location and use of intangibles in a CLA to a particular jurisdiction in the absence of objective benchmarks, such as per-unit cash royalties based on sales of products. Thus, it would be difficult to allocate income to a particular source. For these reasons, the Treasury and IRS determined that, "in the interest of sound tax administration," a taxpayer that is party to a QPCLA is not required to take into account amounts other than "net consideration."

Cross-Licensing Arrangements, QPCLAS, and Net Consideration

The revenue procedure defines "cross licensing arrangement" and "QPCLA," as follows:

   A "cross licensing arrangement" is a contractual arrangement
   between two or more parties that own intellectual property under
   which each party grants to the other a license of specified
   intellectual property that is properly characterized as a license
   under applicable U.S. tax law principles.

   A QPCLA is a nonexclusive, nontransferable patent cross licensing
   arrangement among uncontrolled parties, the subject matter of which
   is limited to the parties' present or future patent rights, as
   specified in the arrangement. If the parties to an arrangement also
   engage in more than de minimis licensing or other transfer of other
   intangible property (including copyrights, trademarks, and know
   how) pursuant to the arrangement, the arrangement is not a QPCLA.
   The determination of whether the licensing or other transfer of
   other intangible property is de minimis is determined under all the
   facts and circumstances.

Thus, an exchange of only patent rights, plus a cash payment by one party to the other, will qualify as a QPCLA. Only a transfer of more than de minimis other rights--such as copyrights, trademarks, and know how--disqualifies the arrangement from QPCLA status. In the revenue procedure, the Treasury and IRS drew a dichotomy between a pure exchange of patent rights and an exchange of patent rights combined with a transfer of other IP rights, which would be more typical of a revenue-generating transaction. (9)

The revenue procedure defines "net consideration" as the amount of consideration other than license rights and de minimis other intangible property received in the taxable year by a party pursuant to the CLA, reduced by the amount of consideration other than license rights and de minimis other intangible property paid in the taxable year by the party pursuant to the arrangement. In virtually all of these arrangements, net consideration will be the amount of cash (if any) transferred by one participant to another in a QPCLA.

Other Aspects of the Revenue Procedure

Tax-Book Consistency. A taxpayer may not use the Net Consideration Method for a QPCLA unless the taxpayer takes into account only the "net consideration," as defined in the revenue procedure, for such arrangement on its audited financial statements (if any), or similar statement in the case of a foreign corporation, for all years ending after February 14, 2007, that the Net Consideration Method is used for tax purposes.

Clear Reflection of Income. The use of the Net Consideration Method will be presumed to clearly reflect a taxpayer's income under section 446(b), thus establishing the amount of gross income generated by the QPCLA.

Withholding and Capitalization. Additionally, under the Net Consideration Method only the net consideration transferred between the parties to a QPCLA during a taxable year will be taken into account for: (i) withholding purposes, (10) and (ii) capitalization purposes under section 263(a) or section 263A.

The revenue procedure provides the following example to demonstrate an application of the Net Consideration Method.

   X, a domestic corporation, and Y, a foreign corporation, each hold
   patents potentially implicated by the manufacture and sale of
   product P. In addition, each actively engages in the manufacture
   and sale of product P on a global basis. Y does not have income
   effectively connected with a U.S. trade or business. In 2007, X and
   Y enter into a QPCLA with respect to their respective patents. In
   accordance with the terms of the QPCLA, $20 million is paid by X to
   Y. The only consideration for the QPCLA taken into account on X's
   financial statements is the $20 million payment made by X to Y. X
   may use the Net Consideration Method to determine its withholding
   obligations and the amount subject to capitalization for federal
   income tax purposes.

Thus, only the $20 million payment made by X is treated as income to Y for withholding tax purposes. Therefore, withholding under section 1442 will apply only with respect to the portion of the $20 million payment by X attributable to U.S. sources. (11) In addition, only the $20 million payment by X is subject to capitalization under section 263(a) or section 263A.

Other Points. The revenue procedure also provides that the Net Consideration Method may be used for a QPCLA by any taxpayer without regard to whether the taxpayer has made a payment of income subject to withholding with respect to the QPCLA. Thus, for example, two domestic parties to a QPCLA that includes either a net cash payment or a purely in-kind exchange could use the Net Consideration Method. A taxpayer wishing to change the reporting of a QPCLA to the Net Consideration Method must request a change in method of accounting within the meaning of sections 446 and 481. In that case, the taxpayer must obtain the consent of the Commissioner under section 446(e) and Treas. Reg. [section] 1.446-1(e)(3).

Effective Date. The revenue procedure generally applies to a QPCLA entered into on or after February 14, 2007. More important, however, the revenue procedure provides that use of the Net Consideration Method for a QPCLA entered into prior to February 14, 2007, will not be raised as an issue by the IRS. If a taxpayer uses the Net Consideration Method described in the procedure for one or more QPCLAs entered into prior to February 14, 2007, and its use of that method is an issue under consideration in examination, in Appeals, or before the U.S. Tax Court, that issue will not be further pursued by the IRS.

Conclusion

The Treasury and IRS have requested comments on the definition of a QPCLA and whether the Net Consideration Method should also extend to other types of CLAs and, if so, under what conditions. Specifically, comments are requested on the tax treatment of CLAs for the joint development of intellectual property discussed in comments in response to Notice 2006-34. The Treasury and IRS carved out these CLAs from the definition of a QPCLA because the parties to such arrangements also engage in more than de minimis licensing or other transfer of other intangible property pursuant to the arrangements. The Treasury and IRS state, however, that they are considering whether it may be appropriate to extend similar tax treatment to those arrangements. (12)

Authorities in the field of intellectual property law indicate that cross licensing arrangements have been a routine part of business operations for decades and are proliferating. Thus, the potential value of the rights that may be subject to CLAs could be very large. The Treasury and IRS exercised sound judgment in reaction to the significant, legitimate concerns expressed by the business community and groups like TEI over potential taxation of these arrangements. The manner in which the government filtered out the hyperbole and focused on the potential serious consequences to the business community will optimally serve as a template for the government to take a similar approach on other contentious issues, such as the pending cost-sharing and capitalization regulations.

(1.) 2007-10 I.R.B. 1.

(2.) See, e.g., Robert M. Milgrim, Milgrim On Licensing [section] 6.04 (1997); Harold Einhorn, Patent Licensing Transactions [section] 2.13 (1984).

(3.) See, e.g., Letter dated Jun. 27, 2005, to the Secretary of the Treasury from the Computer Systems Policy Project, available in 2005 TNT 145-28 (similar letters were reported in the tax press from National Association of Manufacturers, the Semiconductor Industry Association, American Electronics Association, and the U.S. Chamber of Commerce); Letter dated Aug. 11, 2005, to the Secretary of the Treasury from Sen. Lamar Smith, available in 2005 TNT 163-15.

(4.) 2006-14 I.R.B. 705.

(5.) The United States has two taxing regimes for U.S. income earned by foreign persons: (i) a 30-percent withholding tax imposed on U.S. source fixed or determinable annual or periodic income, or (ii) net basis taxation on U.S. or foreign source income that is effectively connected with the conduct of a trade or business within the United States. Gains from the sale or exchange of property derived by foreign persons, even if U.S. source, are generally not subject to tax in the United States unless effectively connected with the conduct of a U.S. trade or business. Fixed or determinable annual or periodic income includes royalties, which are sourced under sections 861(a)(4) and 862(a)(4), according to the location of use of the subject intangible property. Unless otherwise indicated, all section references are to the Internal Revenue Code of 1986, as amended, and the applicable Treasury Regulations.

(6.) See, e.g., Tax Executives Institute, Comments of Tax Executives Institute, Inc. on Notice 2006-34: Taxation of Cross Licensing Arrangements submitted to Internal Revenue Service June 23, 2006 (June 23, 2006) (the "TEI Comment Letter"), available in 2006 TNT 122-64; Notice 2006-34--Comments of the Technology CEO Council (July 14, 2006), available in 2006 TNT 169-13.

(7.) The following points generally paraphrase the TEI Comment Letter.

(8.) For instance, in 1950 the U.S. Patent and Trademark Office (USPTO) received 74,108 patent applications and granted 47,847 patents; by 2000, the USPTO received 315,015 patent applications and granted 175,455 patents. United States Patent and Trademark Office, U.S. Patent Activity, Calendar Years 1790-Present, Table of Annual U.S. Patent Activity Since 1790, available at: http://www.uspto.gov/web/offices/ac/ido/ oeip/taf/h_counts.htm.

(9.) The government expressed interest in this particular point in the notice, asking: "Do parties to a cross license of patents typically also license additional intellectual property rights such as know how, trademarks, trade secrets, etc., associated with exploitation of their patents? What are the circumstances under which such additional rights are, or are not, licensed along with patent rights?"

(10.) The Net Consideration Method applies whether the QPCLA is entered into in advance of, during, or after a patent dispute.

(11.) The example does not address whether Y uses the Net Consideration Method. Accordingly, it appears that Y's use or nonuse of the Net Consideration Method does not affect X's withholding obligation and X does not need to verify how Y reports the arrangement on Y's financials.

(12.) See Treas. Reg. [section][section] 1.482-7(g)(2) & (g)(8), Examples 4 & 5.

Nicholas J. DeNovio is a partner in the Washington, D.C., office of Latham & Watkins LLP and is Global Chair of the firm's International Tax Practice. From 2003-2005, Mr. DeNovio served as Deputy Chief Counsel (Technical) at the Internal Revenue Service Office of Chief Counsel, a role in which he was responsible for the overall management and substantive tax aspects of the Regulatory guidance process of the IRS National Office, and taxpayer-specific guidance such as private letter rulings. A graduate of the University of Miami Law School with an LL.M. from New York University, Mr. DeNovio has practiced with the law firm of Baker & McKenzie in New York and with PricewaterhouseCoopers's Washington National Tax Service. Justin D. Stalls is an associate in the Washington D.C. office of Latham & Watkins LLP where he represents corporations and partnerships in both transaction al and controversy matters. He received his B.A. degree from Trinity University and J.D. from the University of Miami. Before joining Latham & Watkins, Mr. Stalls was an attorney in the IRS's Office of Chief Counsel.