Treasury department and IRS launch review of cross licensing arrangements: detailed information requested from business community.

On March 15, 2006, the U.S. Department of the Treasury and the Internal Revenue Service issued Notice 2006-34 (1) requesting public comments on cross licensing arrangements (CLAs). The Notice requests information across a broad range of issues, including the commercial circumstances that underpin the decision for companies to enter into CLAs, the parameters 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 states that the Treasury and the IRS have "received requests" for guidance on the tax treatment of CLAs and that the agencies expect to issue guidance regarding certain tax issues related to CLAs. (2)

The Notice also posits three theories by which CLAs might be characterized and briefly discusses the very significant tax consequences that would flow from each characterization. The consequences may include 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.

Cross Licensing Arrangements

The Notice describes a CLA as:

   [A] contract between two parties that own intellectual
   property, typically patents, under which each
   party grants to the other a license with respect to
   specified property. These rights in the respective
   patents are often licensed on a nonexclusive and
   nontransferable basis. One party may make to
   the other party one or more cash payments representing
   the difference in value, in the parties'
   estimation, between the parties' respective rights
   covered by the cross license. As in one-way patent
   licenses, other intellectual property related to
   the exploitation of the patented invention such as
   know how, trademarks, and copyrights, may also
   be licensed between the parties.... In some cases
   each of the parties may intend to exploit the cross
   licensed patents by making, selling, or otherwise
   using the patented inventions in its own business.
   In other cases, the parties may operate their businesses
   with their own patents, but seek to avoid the
   risk of patent infringement claims that each might
   make against the other as a result of the exploitation
   of their own patents. In between, there may
   be cases of varying degrees of
   interdependency on each other's
   intellectual property in which
   the parties may seek both to gain
   access to each other's technology
   as well as to mutually avoid
   infringement claims.

Various authorities on intellectual property law contain discussions of CLAs and similar 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 to such an extent that no individual holder of patents can be certain of not infringing on another's patent rights. By entering into a CLA, each patent holder may operate without fear of being charged with infringement of the rights of the other and hence 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 of royalties. (3)

U.S. Withholding Tax Rules

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) of the Internal Revenue Code according to the location of use of the subject intangible property.

Three Alternative Characterizations--Consequences for Tax Purposes

The Notice states that the Treasury and the IRS are considering the treatment of CLAs under three alternative theories.

1. Two-Way License. The Notice states that, under this theory, a CLA would be characterized as a two-way license of intellectual property rights. According to the Notice, the income tax consequences asserted under this theory could include the following:

(i) For tax accounting purposes, gross royalty income equal to the full value of the licensed rights plus any cash payment. The income would be currently includable, except to the extent of any contingent payments, which would be recognized when accrued or received, as the case may be.

(ii) Gross deduction or capitalizable expenditure, equal to the full value of the rights conveyed plus any cash payments made.

(iii) Income sourced under section 861(a)(4) or 862(a)(4), as the case may be, in accordance with the location of use.

(iv) In the case of a foreign recipient of rights under a CLA, a potential U.S. withholding tax on the full value of the rights conveyed to the foreign person plus any cash payment, to the extent that such income is sourced in the United States. Although the Notice does not mention a treaty reduction in the potential withholding tax, there is nothing to suggest that such a reduction would not otherwise be available. (4)

2. Reciprocal Agreement Not to Assert Claims of Infringement. The Notice states that, under this theory, a CLA would be characterized as a reciprocal agreement not to assert claims of infringement. According to the Notice, the income tax consequences asserted under this theory could include the following:

(i) The realized income may be limited to cash received or, alternatively, may also include the gross value of any licensed rights under the CLA, as in the case of the previously discussed Two-Way License Characterization. The Notice does not elaborate on which of these alternatives is more likely.

(ii) If the characterization results in reciprocal services, the source of income would be determined by the location where the services are performed. A withholding tax would be imposed based on where the services are performed. For example, a foreign person would not be subject to withholding tax to the extent that the rights received are in exchange for the performance of services outside the United States.

(iii) Treatment for tax accounting purposes would be similar to that described in the Two-Way License Characterization, i.e., current income (except to the extent of contingent payments) and a deductible or capitalizable expenditure.

3. Sale or Exchange of Property. The Notice states that, under this theory, a CLA would be characterized as a taxable or nontaxable sale or exchange of property. According to the Notice, the income tax consequences asserted under this theory could include the following:

(i) Gross income is realized in the amount of the gain or loss on the exchange of rights under the license and any cash payments under the cross license.

(ii) Nonrecognition treatment may be available under section 1031, in which case an allocation of basis between retained and conveyed rights would be needed.

(iii) Except to the extent of contingent payments, which are sourced as royalties, gain or loss would be sourced where the income recipient resides.

(iv) Treatment for tax accounting purposes would be similar to that described in the Two-Way License Characterization, i.e., current income (except to the extent of contingent payments) and a deductible or capitalizable expenditure.

(v) A foreign person would not be subject to withholding except to the extent of contingent payments, which are sourced as royalties.

Information and Comments Requested

The Notice requests the public to provide information on more than a dozen subjects, along with sample agreements and any corporate policy guidelines relating to the strategy and negotiation of CLAs. The information sought is detailed and precise, and the Notice manifests the Treasury Department and IRS's apparent intention to analyze thoroughly the rights and obligations of parties to a CLA, as well as treatment of these arrangements under intellectual property laws. The information sought, which is described as "critical" to the analysis and guidance process, can be summarized into four categories.

1. Factors used by companies to determine whether or not a CLA is appropriate under a given set of circumstances, along with the relevant terms of the agreement. The information requested is consistent with the contractual rights and obligations that the Treasury and the IRS would consider in determining which of the three proffered alternative tax characterizations is proper for a CLA. For example, the Notice asks: (a) What are the circumstances in which parties engage in CLAs out of a mutual need for one another's patents for purposes of operating their own businesses? (b) What are the circumstances in which parties have no need for each other's know how, technology, underlying patented inventions, or similar rights, but still seek protection against the risk of infringement claims by entering into a patent CLA? What benefit does entering into a CLA generate in such a case? (c) In cases where parties primarily or only seek protection from infringement claims, might parties nevertheless style their agreement as a CLA granting affirmative rights to make, sell, and use technology rather than as a reciprocal covenant not to sue one another for infringement? If so, why?

2. Whether and to what extent CLAs cover not just patents, but also other intangible property such as know how, trademarks, and trade secrets.

3. The methods by which industry values the rights conveyed in a CLA and determines any net cash payments, along with how these methods compare with methods for valuing a typical one-way license of intangible rights.

4. Financial accounting and foreign tax treatment of CLAs. The Notice sets May 31, 2006, as the deadline for the submission of comments. The scope and depth of the information requested indicates that, although the Treasury and IRS have a degree of understanding of the operation of these agreements, they also understand the complexity of CLAs and think more study is needed before published guidance can be developed.

Concluding Thoughts

Authorities in the field of intellectual property law indicate that CLAs have been a routine part of business operations for decades. Advances in technology in recent years have contributed to the proliferation of CLAs, as multinationals seek rapid innovation to gain a competitive advantage, while seeking to avoid protracted controversy with competitors on overlapping products and processes. Thus, the potential value of the rights that might be subject to CLAs could be very large.

Informal comments by tax executives at recent meetings (including TEI's 2006 Midyear Conference) confirm the importance of CLAs to a significant number of companies and industries. Business development and legal executives at companies sometimes negotiate these agreements without full involvement by the Tax Department. Accordingly, it is important for Tax Departments to determine the scope and terms of CLAs in their companies so that they can make a general assessment of the tax consequences that would flow from the guidance that might be forthcoming from the government.

The Notice strongly suggests that the guidance process is well underway. Therefore, it is important for affected taxpayers and industries to formulate a plan to provide the requested information to the Treasury and the IRS, in order to provide input in the guidance process so that all relevant factors, including key policy issues of promoting innovation and avoiding protracted disputes, are considered.

(1) 2006-14 I.R.B. 1 (Mar. 15, 2006).

(2) The Notice does not state whether the requests for guidance have been in the context of parties seeking published guidance, private letter rulings, or other non-published guidance, for example, in the course of an IRS Examination. Recent industry group and congressional letters to the Treasury Department have discussed the importance of CLAs and expressed great concern about potential IRS views of these arrangements. See, e.g., Letter dated June 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 the 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; Letter dated Nov. 15, 2005, to the Secretary of the Treasury from Sen. George Allen, available in 2006 TNT 16-16.

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

(4) There are various reporting requirements for claiming such a reduced rate under an applicable income tax treaty.

NICHOLAS J. DENOVIO is a partner in the Washington, D.C., office of Latham & Watkins, LLP, and AKEMI KAWANO is an associate in the same office. Mr. DeNovio previously served as Deputy Chief Counsel (Technical) for the Internal Revenue Service.