09 Oct Technology Transactions Taxation
We are going to cover a few selected topics in regards to the taxation of technology transactions that come up again and again in a technology practice. We are not going to have a comprehensive summary of all of the tax issues related to technology. And in fact, this is not a separate area except maybe with regard to credits, special deductions and software, but rather is an application of existing tax concepts to a certain type of transaction involving technology.
Now, however, we want to hit the high points and raise the bigger issues with hopefully the idea that you can come away from this with a framework and outline for spotting tax issues and where the tensions are in a typical transaction. One threshold issue that we often run into in this area is the characterization of a transfer of technology as a sale or a license. The consequences can be very high – a 20% tax rate spread on a sale or licensor side because the capital gains rate is currently 15% federally and ordinary income rates cap out at 35%.
A sale typically may qualify for capital gains treatment, a license will not. So an initial issue with any sort of technology is whether we have a sale or exchange. This analysis is substance based. It does not depend on the label. So you can have a sale under an exclusive license agreement. Similarly, you can have for tax purposes a mere license under what purports to be an assignment agreement.
Outside of 1235, which we are going to talk about in a minute, in order to obtain the special capital gains tax treatment, the technology must be a capital asset and must be held for at least one year. With regard to patents, the holding period starts when the patent is reduced to practice. Now, reduced to practice for this purpose in the tax world means something different than what it means in the patent world. Reduced to practice for this purpose only requires that the idea is reduced to a written description.
A couple of other criteria for determining patent capital assets status.
Inventory property or property held for sale to customers in a trade or business cannot be a capital asset. This becomes significant for professional inventors of course who sell patent after patent after patent. There must be a transfer of all substantial rights in order to qualify for capital gains treatment. With regard to the general capital asset definition of Code section 1221, there may be fields of use and geographical limitations. Case law supports capital gain treatment when carving up patents and selling something less than all fields of use or world-wide rights.
If, in fact, we have a transfer of all substantial rights, and we have met the holding period requirements and it is a capital asset and not inventory property or what we call a Section 1231 Asset, which is depreciable property used in a trade or business. In that case, we have capital gains treatment to the seller and potential depreciation recapture, although research and development expenses are not recaptured. That is one of the benefits of R&D expense treatment. One thing to keep in mind is that capital asset treatment does not apply to self-created copyrights.
On the buy or licensee side, in the case of a sale, a buyer will be entitled to amortize the asset over 15 years under Section 197. In the case of know-how or patents and copyrights acquired as part of a trade or business or software acquired as a part of a trade or business, subject to exceptions, of course, the property is generally subject to 15-year amortization and depreciation over its useful life.
One thing to note here is that the Associated Patentee rule provides for an immediate deduction for the full amount of contingent payments made in connection with the acquisition of a patent. By the way, the fact that the payments are contingent is not going to affect whether it is treated as a sale or license, but you might get the same result on a licensee side, i.e., immediate deductibility.
What I call the “Associated Patentee Character Converter” leverages the Associated Patentees idea. In other words, capital gain treatment on the sale side; ordinary deduction treatment on the buy side. The licensee or assignee of the property. In the case of a license, the distinguishing factors typically are whether there has been a transfer of all substantial rights. A non-exclusive right would not be all substantial rights. That would be a mere license for less than the remaining useful life would not be a transfer of all substantial rights. That would be a mere license. A transfer subject to an existing license may not be a transfer of all substantial rights.
Having a right to terminate the license or the assignment would defeat a transfer of all substantial rights. However, a security interest and a right to terminate on breach probably would not. A right to prevent unauthorized disclosure of trade secrets is probably essential to a transferee in order for that transferee to acquire all substantial rights. The licensor’s tax consequences, in other words, the person receiving the royalty or licensee payments, if it is a license, are that they have ordinary income and not capital gain, although there may be opportunity for some deferral of advance payments if economic performance has not occurred. And the income is likely what we call “personal holding company income” which can be a bad type of income for S corporations and C corporations. On the licensee side, the consequences are that the royalties are deductible unless the license is used to create an asset with a useful life of more than one year, in which case, the asset would be depreciable.
Now, we need to add one more category to sales versus license and that is services because sometimes what you really have is a services transaction not a license and in fact, with most transfers of technology that I see, there is a substantial service component that goes along with it. The real question here is what the true nature of the transaction is and whether the true nature is a license for technology or if it is just a services transaction.
So which is incidental to the transaction, the services or the technology?
Keep in mind that if you do end up having something that is arguably a service transaction, we have to confront Section 409A, which is far beyond what we are going to talk about here. But suffice it to say that there are very substantial penalties on non-qualified deferred compensation agreements and a license that gets re-characterized as a service agreement could very well be a non-qualified deferred compensation agreement for employees and employee-like people because we have performance of the services now and payment in a later year.
As you can see, there are lots of hurdles to jump through in order to get capital gains treatment under Section 1221 or 1231. The holding period might be hard to meet. The biggest hurdle tends to be that most inventors I know do not just come up with one great idea in their lifetime and then stop. They have lots of ideas and they have lots of patents, and they are worried about being a professional inventor. In other words, what they end up with is inventory not qualified for capital gain treatment.
So Congress has addressed this use with Code Section 1235, which provides automatic long-term capital gain treatment for sales of patents or patentable inventions without regard to holding period. And secondly, it applies to professional inventors. So somebody who has what would otherwise be inventory property can still qualify.
To qualify for this automatic long-term gain treatment, the holder has to be an individual who created the patent, the inventor basically, or someone who acquired an interest from the inventor and not the employer of the inventor for money, not as a gift prior to its reduction to practice. Now, remember the reduction to practice standard that I gave you earlier was very loose, not the patent standard. The reduction to practice standard here does refer back in the regulations to the patent standard because, as you can see, it is in the taxpayer’s interest and taxpayer friendly to have a more stringent definition of reduction to practice.
Again, there must be a transfer of all substantial rights in order to qualify under Section 1235. However, in the case of 1235, you cannot have a geographical or field-of-use limitation. The IRS view in the regulations requires a transfer of all rights not limited by geography that the patent covers, and all uses covered by the patent not carved up in different fields. Importantly, for reasons I will share later, section 1235 treatment is available for partners in a partnership or members of an LLC taxed as a partnership. So in other words, a person can become a holder in a partnership that owns the patent and get 1235 treatment. It is not available in the case of a transfer to a related party, family, or persons who are 25% commonly owned, and it is not available in a hired-to-invent scenario. In other words, the employer of the creator does not end up with 1235 treatment.
There are a few traps under 1235. The biggest one is to ensure that when we do put together a partnership that the investors in the partnership acquire their interest in the patent prior to its reduction to practice. Sometimes, you see people run afoul of the sale to related party analysis under typical structures, and again if you are acquiring the patented technology from an R&D facility, you may end up typically acquiring it from the employer and not from the actual creator, which will not qualify under Section 1235. There are certainly some easy ways to structure around some of these and avoid these traps if you are aware of them.
Let us move on to reducing the tax rate on gain from a technology transaction to avoiding it all together.
Non-recognition: Where this comes up typically is a scenario where a transferor wants to incorporate and very often, not enough thought goes into this process because most of the time, of course, the inventor or the creator who is going to incorporate his technology and turn it into a business certainly can qualify for non-recognition treatment. But it does not happen by magic. It happens pursuant to Section 351 of the Code in the case of corporation, or 721 in the Code in the case of partnership or LLC taxed as a partnership.
Both of those sections require a transfer of “property” in order to get non-recognition, non-taxable treatment. And property is broadly defined to include legally protectable knowhow and secret processes.
With regard to R&D partnerships, case law gives us some clear direction on how to structure these. In one case, and they are described in the written materials, the partnership had no real possibility of ever exploiting the technology, and the developer corporation was very much relied on to turn the technology into a business. So it was not likely and there was only a possibility that the partnership would ever act. The taxpayer lost in that case and did not get the R&D deductions.
In another case, the court said that the partnership has to be able to enter the business, and one of the bad facts in that case was a one dollar option or a nominal price option in the developer corporation to acquire the technology. This was a very bad fact in connection with this factor of having a realistic possibility of entering its business. But where the developer had a significant cost option or a fair market value option to acquire the technology and the partnership itself was capable of developing the business if the developer did not, in that case, the taxpayer did win and was entitled to deductions under Section 174.
Let us switch gears here a little bit and talk about some of the international issues. In the foreign area, things can get very interesting for a technology lawyer and I would like to break this down into really two categories. One is the related party and the other is the unrelated party scenario. In the unrelated party scenario, if you are negotiating an international transfer of technology, the first thing to always be aware of are potential withholding issues. If there is a license-out of the technology, we have to be concerned about foreign withholding taxes on the royalties coming back. If it is a license in, it is U.S. withholding taxes on the royalties going out.
And one of the big concerns is, first of all. whether we can get around withholding altogether by allocating some of those payments to non-foreign source, allocating some of those payments to income that might not be subject to withholding, especially in areas such as e-commerce where there really is a strong foreign service component that may not attract withholding tax.
In recent years, countries have wised up to this allocation strategy and you will find many countries being much more aggressive about imposing withholding taxes on something that we might consider services as opposed to license fees. So on the outbound license side, it is very important to be very cognizant of foreign law and to not assume that it is going to be consistent with U.S. definitions. Similarly, countries that impose withholding taxes on source might not follow US legal concepts. Source might be based on where the technology is used, which is the U.S. rule, or it might be based on the residence of the payor. Again, some of this is counter intuitive and requires paying attention to local law and importantly, consulting the relevant income tax treaties.
On the license inside, where payments are being paid out, generally, the U.S. imposes a 30% withholding tax on payments of U.S. source royalties and license fees paid to foreigners. There is a reduction by Treaty for most industrialized nations, but that treaty rate must be claimed and it does not happen automatically. And there is a process for claiming it and a reporting regime that must be complied with.
So it is something that needs to be paid attention to and in the planning process and in the drafting process, there should be covenants and provisions ensuring that the parties will be in a position to get income tax certificates, etc., and be able to actually claim treaty exemption. There is also an exemption for effectively connected income, but that is one that applies not quite as often.
The practitioner also should be aware of the several anti-deferral regimes that the U.S. applies in order to prevent the migration of technology offshore. There are several traps in this area where a U.S. company decides to locate his technology in a tax haven jurisdiction. They are manageable. They typically provide us with a set of rules that we have to navigate in order to accomplish a good tax result.
For example, a foreign controlled corporation, which is a foreign corporation that is more than 50% owned by 10% U.S. shareholders, will be a CFC and a portion of its royalty income will be taxable to its US shareholders unless it is engaged in an active trade or business of licensing. That may not be the end of the world, but something to be aware of.
If the company is a PFIC (Passive Foreign Investment Company), the US shareholders would be taxed on the passive income of the foreign company. Importantly there are what we call the “super royalty provisions” under which a U.S. company that simply transfers its technology to a foreign entity is required to realize income commensurate with the technology in the United States.
In a related party scenario, one thing the technology practitioner ought to be aware of is the use of a cost sharing agreement. A cost sharing agreement is an arrangement where each affiliate in a world-wide group will buy in to a technology or contribute to the cost of creating an intangible and then, share income commensurate with its markets. It avoids the necessity of having licenses back and forth. It typically would avoid withholding taxes and hopefully avoid to transfer pricing adjustments.
So when you as a practitioner get involved in drafting inter-company license agreements, you have all of these international issues that we discussed, but you also have the overlay of Code Section 482, transfer pricing, as well as some of the other opportunities with regard to cost sharing.