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Taxation of Intellectual Property: Federal Corporate Income Tax Implications

Minimizing Tax Liability and Improving Compliance in IP Ownership and Transactions

presents

Today's panel features:Joseph Fletcher, Partner, Morrison Foerster, San Francisco

Arindam Mitra, Principal, Deloitte Tax, Washington, D.C.

Thursday, September 24, 2009

The conference begins at:1 pm Eastern12 pm Central

11 am Mountain10 am Pacific

The audio portion of this conference will be accessible by telephone only. Please refer to the dial in instructions emailed to registrants to access the audio portion of the conference.

A Live 90-Minute Audio Conference with Interactive Q&A

© 2009 Morrison & Foerster LLP All Rights Reserved

Taxation Of Intellectual Property: Federal Corporate Income Tax

Implications Teleconference

Sept. 24, 2009

Joseph K. Fletcher, IIIPartner, Morrison & Foerster LLP

[email protected]

2

Overview

• IP as “property”: Sect. 351 and other implications• Sale vs. license of IP• Domestic issues• Acquiring IP• Self-created IP• Recent developments• Conclusion

3

IP As Property

• Is the IP property?• All substantial rights in the IP must be transferred• Patents or patentable• Copyrights or copyrightable• Trade secrets/know-how that is not patentable or copyrightable• Labels are not determinative (e.g. “know-how”), Rev. Rul. 64-56• Generally the exclusive rights to a trade secret/know-how, until it

becomes public knowledge, will be considered property. Rev. Rul.71-564

• IP as distinguished from services (services can be ancillary andsubsidiary to transfer, and part of the “property”; but, services cannot themselves be “property”)

• Why does it matter -> Must be “property” to be part of a good Sect. 351 transaction (contribution to corporation) or to be a tax-free contribution to a partnership/LLC under Sect. 721

4

IP As Property (Cont.)

• Is the IP property? (Cont.)• Case law is much more lenient than the IRS position

- United States v. Stafford, 727 F.2d 1043 (11th Cir. 1984); contribution of letter of intent held to be “property,” for purposes of Sect. 721 (letter was unenforceable under GA law, the relevant state law; the court held that since the parties viewed it was having value, it was “property”)

- E. I. DuPont de Nemours v. United States, 471 F.2d 1211 (Ct. Cl. 1973); grant of non-exclusive patent rights to a wholly-owned subsidiary was “property,” for purposes of Sect. 351

• In one GCM, the IRS considered the divergence of the IRS view and case law GCM 36922 (Nov.16, 1976)

• When do these problems arise?- Retention of license or license back by “seller” of IP- Contribution of IP and services to corporation or partnership

5

Sale Vs. License

• Is it a sale or a license?• For sale treatment, “all substantial rights” must be transferred

• What does this mean?• Rights to make, use, offer, sell or improve• Full duration of IP or indefinite term (for trade secrets until public)• Right to sub-license • Complete geographical territory (nation, limited cases address where

only one region is relevant)• For all fields of use (limited case law establishing that if there is only one

field of use, transfer may be for this specific field; new cost-sharing regulations permit break-down of rights by field of use in cost-sharing agreement)

6

Issues Domestic

• Sale (“all substantial rights”) Capital gains

• Sale (“all substantial rights”) Not “personal holding company income”• Rev. Rul. 75-202

• License Ordinary income to licensor

• License License fee general deductible by licensee

7

Amortization

• Sect. 197• Acquired as part of a trade or business• If not, normal Sect. 167 rules apply• If Sect. 197 applies, 15-year straight-line• Pre-Sect. 197 history

• Sect. 167• Separately identifiable intangible• Fixed useful life (no such requirement for Sect. 197)• Amortization over useful life• Pre-Sect. 197, this was the only approach to amortize IP (see Newark

Morning Ledger v. United States, 507 U.S. 546 (1993)

• Sect. 174• Immediate “expensing” of R&D costs• Results in self-produced IP having a zero tax basis, in most instances

8

Acquiring IP

• What is acquired?

• 15-year straight-line

• Goodwill (and patents acquired together with a business). Sect. 197(d)(1)

• Trademarks and trade names. Sect. 197(f)

• But not: • Film rights or soundtracks. Sect. 197(e)(4)(A)• Patents acquired outside of acquisition of trade or business (rather,

over remaining life under one of a number of methods including contingent payment method Rev. Rul. 67-136; income forecast method; or ratably over remaining life). Contingent payment method has same effect as current deduction, but with Sect. 1245 recapture. For ratably, Treas. Reg. Sect. 1.167(a)-14(c)(4)

9

Acquiring IP (Cont.)

• Hardware 5-year. Sect. 168(d)(3)(B)

• Software 36-month (no conventions) (if not “bundled” with hardware). Sect. 165(f)(1)

• Services (stated separately) expense?

• Sect. 197, if acquired together with a trade or business, general amortization rules otherwise

10

International Issues

• Developing IP in low-tax jurisdiction (as opposed to transferring it there later) may produce large tax savings• How does it get there?

• Buy-in (for FMV)• License

• Identify “traps” in tax due diligence of U.S. acquisition “target”• Transfers of IP for no consideration or for stock • Non-arm’s-length pricing.

• Is an acquisition an opportunity to “move” IP to lower-tax jurisdiction?

• Have IP holding company purchase IP directly, instead of moving the IP there later

• Treaty structure from low-tax jurisdiction

11

Cross-Border Licensing

• Sale Capital gains• Corporate 35%• Individual 15% (in many cases)

• Sect. 1235 for patents• Applies to individual “inventor” and “holders” (holders must obtain interest

prior to reduction to practice)• Sale is LTCG (automatic long-term holding period; need not actually hold for

> one year)• Similar cases to the general “all substantial rights” cases - sale must be

transfer of all substantial rights.• No withholding tax• Sourcing Residence of seller. Sect. 865(d)(1)(A)

• Foreign or U.S. source has treaty implications and foreign tax credit implications

• Sale, foreign person generally not subject to tax on sale of U.S. capital asset• U.S. person may prefer foreign-source, for foreign tax credit purposes

12

Cross-Licensing

• Withholding tax on mere license

- 30% absent treaty- Often 0% under treaty

• Cross-licensing – IRS Notice 2006-34

- Netted, 1031-type treatment- Sourcing issues

13

International Issues

• “Inbound” licensing (to U.S.)• Sale vs. license

• Sale Gain, and non-resident is not taxed on it (and foreign-source)• But, from a commercial perspective, license may be far superior

• U.S. imposes 30% withholding, absent treaty• Royalty may be net of tax, but someone bears the cost• Withholding taxes are creditable under many tax systems, but credits are

imperfect.• Many favorable treaties

• U.K, Germany, Switzerland, Netherlands, Sweden, Norway, Japan (new treaty), Hungary (no “limitation on benefits” provision, but new treaty negotiated with LOB provision) 0%

• Many others have reduced withholding: China, Mexico 10%, France 5%

• But, tax havens: Cayman, Bermuda, Bahamas 30% (no treaty)

14

International Issues (Cont.)

• “Treaty shopping”

• Most modern treaties have a “limitation on benefits” provisionOld treaties (such as Hungary) lack such LOB provisionse.g., company or individual in non-treaty country wants to license IP to

U.S. Absent treaty, withholding rate is 30%. Licensor establishes Hungarian company, licenses IP to Hungarian company; and Hungarian company in turn sub-licenses to the U.S. No withholding on royalties under treaty (Art .11(1)), small tax in Hungary. New treaty has been negotiated with Hungary

• Conduit issues

15

Current Developments

• Xilinx- Taxpayer win in Tax Court- Ninth Circuit holds that the “arm’s length” standard is a mere regulatory gloss- Rehearing en banc granted by Ninth Circuit

• Final and temporary cost-sharing regulations

16

Final Recap Of When IP-Tax Issues Arise

• License• Domestic – Sale vs. license (“all substantial rights is sale, title of agreement irrelevant);

ordinary income vs. capital gains• Cross-border – Sale vs. license; withholding tax vs. capital gains; treatment of royalties

received by controlled foreign corporation (special rules for deferral vs. no-deferral)

• Joint venture• Is the IP property (for contribution to partnership or corporation, sections 721 or 351)?• Are there Sect. 367(d) or Sect. 482 considerations

• Migration of IP• Contribution for shares or partnership interest vs. buy-in vs. license• Sect. 367(d) or Sect. 482 issues

• Licensing or sale together with hardware or services• Amortization and depreciation depends on whether IP, hardware and services are separately

stated

Copyright © 2009 Deloitte Development LLC. All rights reserved.

Taxation Of Intellectual Property: Federal Corporate Income Tax Implications

Teleconference

Sept. 24, 2009

Arin Mitra, Deloitte Tax [email protected]

Copyright © 2009 Deloitte Development LLC. All rights reserved. 1

Agenda

• Defining intangibles

• Licensing (Treas. Reg. §1.482-4)

– Methods and commensurate-with-income standard

• Cost-sharing (Treas. Reg. §1.482-7)

– Temporary regulations and coordinated issue paper

– Methods and commensurate-with-income standard• CUT

• Acquisition price

• Income method/investor model

• Market capitalization method

• RPSM

• Safe harbor


Defining Intangibles

Treas. Reg. §1.482-4(b):

“For purposes of Section 482, an intangible is an asset that comprises any of the following items and has substantial value independent of the services of any individual –

• Patents, inventions, formulae, processes, designs, patterns, or know-how;

• Copyrights and literary, musical, or artistic compositions;

• Trademarks, trade names, or brand names;

• Franchises, licenses, or contracts;

• Methods, programs, systems procedures, campaigns, surveys, studies, forecasts, estimates, customer lists, or technical data; and

• Other similar items …”


Evaluating Transfers Of Intangible Property (Treas. Reg. §1.482-4)

• Pricing methods

– Comparable uncontrolled transaction method (CUT)

– Comparable profits method (CPM)

– Profit split method

– Unspecified methods


Evaluating Transfers Of Intangible Property (Cont.)

• Best method” rule adopted

• Generally, “royalty" preferred over lump-sum payments– Lump-sum payment may be adjusted at any time– Lump-sum treated as the present value of the royalty

stream over the useful life of the intangible

• Prior to selecting the “best method,” a functional analysis should be performed

• Functional analysis of the transaction is critical– Identify functions, risks and intangibles; and– Evaluate the value-enhancing elements of the transaction


Comparable Uncontrolled Transaction Method

Comparable uncontrolled transaction (CUT) method

• Requires data on comparable intangible property transfers between uncontrolled parties under comparable circumstances

• Intangible property relates to same type of products or processes within the same general industry or market

• Intangibles have “similar profit potential,” i.e. direct comparison of net present values or circumstantial evidence

• Circumstances of the transfer of intangibles should be comparable– Time when transfer occurs, and– Separate transactions or part of integrated transaction


Comparable Uncontrolled Transaction Method (Cont.)

Factors in determining comparability of circumstances

1. Terms of the transfer (i.e., rights granted, exclusivity, limitations)

2. Stage of development of intangible (i.e., government approvals)

3. Rights to updates, revisions or modifications4. Uniqueness of the property and period for which it remains

unique5. Duration of the license and termination of the negotiation

rights6. Economic and product liability risks of transferee7. Existence of collateral transactions or ongoing business

relationships8. Functions performed, including any ancillary services


Comparable Profits Method

Comparable profits method (CPM)

• Operating profit method where the license or royalty is derived from range of operating profits

• Application of “profit level indicators” from “comparables” to financial data of “tested party” within taxpayer group

• CPM steps involved

Step 1: Select tested party and the comparables

Step 2: Select profit-level indicators

Step 3: Apply indicators to comparables, to derive an arm’s length range

Step 4: Derive transfer price for intangibles being used


Comparable Profits Method (Cont.)

• Tested party: Ordinarily the party with the most reliable data requiring the fewest adjustments

• May not be the U.S. party

• Selection of comparables– “Broad similarity” required– Significant product diversity and some functional diversity is

acceptable– Inter-quartile range is applied

• Test of post-royalty profitability of the tested party. relative to the inter-quartile range established by the comparables


Profit-Split Method

Profit-split method

• Considers combined operating profit or loss attributable to each controlled transaction, by reference to relative value of each controlled taxpayer’s contribution to that combined operating profit or loss

• Two alternative profit-split methods may be used: Comparable profit-split method or residual profit-split method


Profit-Split Method (Cont.)

Comparable profit-split method

• Requires the identification of relative profit splits earned by uncontrolled parties engaged in comparable transactions

• Method depends upon access to financial data regarding each uncontrolled party’s share of the combined profits

Residual profit-split method

• Each of the related parties is given a return for its routine functions and intangibles

• Any “residual” combined profit is then allocated between the parties based on the relative value of each party’s valuable intangibles


Unspecified Methods

Unspecified methods

• “Should take into account the general principle that uncontrolled taxpayers evaluate the terms of a transaction by considering the realistic alternatives to that transaction, and only enter into a particular transaction if none of the alternatives is preferable to it”

• Examples of unspecified methods– Bona fide offers– Investor model or the income method– Transferee’s return on investment– Transferor’s return on cost


Commensurate With Income

Amendment to Sect. 482 by Tax Reform Act of 1986

“In the case of any transfer (or license) of intangibles property… the income with respect to such transfer or license shall be commensurate with the income attributable to the intangible”


Commensurate With Income (Cont.)

1.482-1

– Amended returns are not permitted to decrease taxable income in the U.S.

1.482-4

– (f)(2)(i): Defines periodic adjustments in accordance with the commensurate-with-income standard

– (f)(2)(ii): Lists specific requirements (exceptions) for periodic adjustments

– (f)(2)(ii)(D): Five-year time limit to periodic adjustments (safe harbor)

– (f)(5): Lump-sum payment provisions (equivalent royalty)



Periodic adjustments overview

• Provides for periodic adjustments to the consideration paid for the inter-company transfer of intangible property, such that the consideration is commensurate with the income attributable to the intangible property

• Considers deviations from “foreseeable profits and costs,” i.e. plus or minus 20%



Identical CUT Comparable CUT Other Methods

• Requires “substantially the same” circumstances

• Tests consideration paid in the first year only

• Requires “comparable”circumstances

• Tests each of the following facts

– Written controlled agreement

– Existing uncontrolled agreement

– Uncontrolled agreement substantially similar

– Controlled agreement limits use of the intangible

– No changes in functions performed

– 80%-120% test of actual aggregate profits

• Tests each of the following facts

– Written controlled agreement

– Consideration was arm’s length in the first year in which substantial consideration was to be paid

– No changes in functions performed

– 80%-120% test of actual aggregate profits


Cost Sharing Is A Major Tax Planning Tool

• For many companies, intangible properties are key value-drivers

• Locating some of those value-drivers and their associated income in tax-advantaged jurisdictions is one of the focuses of international tax planning

• In recent years, the favored method of effecting such planning was through cost sharing

• Basics– Two or more related companies agree to share future R&D costs in

proportion to future benefits

– If future R&D will build on current technology developed by one of the companies, other cost sharing participants must buy-in


Cost-Sharing Essentials

• At least two parties required (related or not)

• Written agreement

• Designates division of intangible rights that each party will obtain through the arrangement

• Specifies method of sharing costs consistent with division of intangibles rights and expected benefits

• Buy-in arrangement for existing intangibles

• BIG ADVANTAGE: No royalties required for use of intangibles developed under the arrangement


Before Temporary Regulations

• Companies often supported modest buy-in payments using guidance in §1.482

• Prior to 1996, the guidance was minimal and reiterated the arm’s length standard

• With specific cost sharing regulations issued in 1996 (§1.482-7), the value of the buy-in payments was determined using the transfer pricing regulations pertaining to the transfers of intangibles (§1.482-4)

• Most companies used the residual profit-split method

– A specified method under the §1.482-4 regulations

– Application characterized by a rapid ramp-down of the value attributable to pre-existing IP

– Foreign subsidiary earns all intangible income after ramp-down


Cost-Sharing Buy-In: Payment Or PCT

• Required for any pre-existing intangibles made available to cost sharing arrangement for further development

• Form of payment– Lump-sum– Installments– Royalty

• Primary issue: Value of pre-existing intangibles

• Temporary regulations• Platform contribution transaction, or PCT

– Extends beyond normal definition of intangible assets– Includes value of R&D workforce in excess of cost– Goodwill, going concern value and business opportunity are

not explicitly included in platform contributions– Proposed valuation methods may include value of these

assets in PCT


Methods For Evaluating PCT (Treas. Reg. §1.482-7)

• CUT– Comparable licenses can be difficult to find in many cases

• Acquisition price– Continue to advocate acquisition prices as useful starting point for

valuing acquired intangibles– Treatment of financial statement goodwill under temporary

regulations- Suggest taxpayers attempt to allocate goodwill among platform

contributions such as workforce in place, in-process R&D, existing IP and other intangibles

- Indicate that if such allocations are not possible, reliability of the acquisition price method is reduced


Methods For Evaluating PCT (Treas. Reg. §1.482-7) (Cont.)

• Income approach – May leave PCT payor with little more than routine returns– Temporary regulations require taxpayers to analyze realistic

alternatives of all CSA participants– Example: USP and FS enter CSA, and USP makes external

contribution– FS’ realistic alternative to cost sharing is to license

intangibles– USP’s realistic alternative to cost sharing is to develop

intangible asset itself and license it

Present value of intangible developed cost + present value of PCT = present value of license

Estimated present value of PCT = present value of license –present value of intangible developed cost

• Market capitalization– Used where substantially all of PCT payee’s existing IP required for

the PCT payee’s business are covered by a PCT


Methods For Evaluating PCT (Treas. Reg. §1.482-7) (Cont.)

• Profit split– Temporary regulations permit residual profit-split method (RPSM)

to be used only when two or more participants to a CSA make non-routine external contributions - USP contributed foreign rights to technology intangibles- FS contributed foreign rights to marketing intangibles

– Under RPSM, foreign participants in CSAs can earn non-routine returns

– To qualify, foreign participants will likely have significant functions and substance- Foreign development of marketing intangibles- Foreign development of technology intangibles, or- Foreign development of manufacturing intangibles


Issues In Applying Acquisition Price

• If only IP is acquired, no adjustment to acquisition price

• If acquisition includes other assets, e.g. company acquisition, value obtained by adding total liabilities and deducting net tangible assets generally requires adjustments

– Taking out tangible property does not take into account value of routine business:

• Book value of tangible property differs from market value or replacement cost

• Book value does not take into account expected growth of routine business

– Based on the facts and circumstances, the value of cash flow associated with IP that is not in existence or not in the process of being developed should not be part of the PCT payment, i.e. cash flow far out (?) in the future

– Purchase price includes growth potential not attributable to current IP


Issues In Applying Income Approach

• Two drivers for reliable application of the income method– Projected cash flows or income

– Discount rate

• Income method requires an estimate of the “average” or “expected” income – Actual cash flow will be higher than this number 50% of the time

and lower 50% of the time

– Most companies’ projections are not at the average and tend to be “optimistic”

– Business projections beyond 1-3 years typically do not exist

– In many cases, businesses do not have enough history for measuring probability of project failure

• Other types of projections• Most likely, contingent on success, etc.


Issues In Applying Income Approach – Discount Rates

• Different assets may have different discount rates

• Discount rate for cost sharing may differ from discount rate forlicensing

• Different payment forms (e.g., lump sum, royalty) and income streams (e.g., sales, profits) may have different discount rates

• The temporary regulations also recognize that publicly availablecost-of-capital data are after-tax, and that common valuation computations are usually after-tax


Issues In Applying Income Approach – Discount Rates (Cont.)

• Discount rate depends on what is being discounted

• WACC is used to discount debt-free, after-tax-free cash flow – WACC is after-tax weighted average cost of capital

• Discount rate for fixed costs– Lower than WACC, closer to cost of debt

• Discount rate for operating profit – Higher than WACC because before-tax

• Discount rate for revenues– Lower than WACC to preserve PV of operating profit

– Close to discount rate for routine operating profit

• Discount rate for residual profit– Higher than discount rate for operating profit

Caveat: If not dealing with expected values, then any WACC-based discount rate will not be appropriate


Issues In Applying Income Approach

Probability Of Successful ExitYears to Exit 10.0% 20.0% 25.0% 30.0% 35.0% 40.0% 50.0%

2 264% 157% 130% 110% 94% 82% 63%13.2 6.6 5.3 4.4 3.8 3.3 2.6

3 148% 97% 83% 72% 63% 56% 45%15.2 7.6 6.1 5.1 4.3 3.8 3.0

4 105% 72% 63% 55% 50% 45% 37%17.5 8.7 7.0 5.8 5.0 4.4 3.5

5 82% 59% 52% 46% 42% 38% 32%20.1 10.1 8.0 6.7 5.7 5.0 4.0

6 69% 50% 45% 41% 37% 34% 29%23.1 11.6 9.3 7.7 6.6 5.8 4.6

7 60% 45% 40% 37% 34% 31% 27%26.6 13.3 10.6 8.9 7.6 6.7 5.3

Source: Andrew Metrick, “Venture Capital and the Finance of Innovation,” Wiley

Based on 15% cost of capital


Issues In Applying Income Approach – Useful Life

• Temporary regulations recognize life of platform contribution isfinite. Specifically, preamble states:

“The period of enhanced results that justifies the platform investment in such circumstances effectively would correspond to a finite, not a perpetual, life.”

Other references found in §1.482-7T(c)(1) & §1.482-7T(c)(5) Example

• Although IRS conceded that useful life of a platform contribution is finite, IRS is likely to argue that useful life is VERY long


Cost Sharing - IDC

• No major changes in definitions of intangible development cost or reasonably anticipated benefits shares

- Except for stock-based compensation, is not a significant area of IRS adjustments

- No change to the 80/120 safe harbor

• Temporary regulations increased documentation- May indicate that IRS will scrutinize more closely in the future


Cost Sharing – New CWI

• Temporary regulations include a CWI provision

• CWI adjustment triggered when the ratio of cumulative present value of total operating profit and cumulative present value of total investments falls below 0.667 or above 1.5

– Based on the actual total operating profit of the PCT payor, is not projected operating profit

– Presumption of WACC rather than appropriate discount rate

• Can avoid adjustment by applying exceptions

– Non-routine profit rather than total profit

– Appropriate discount rate rather than WACC

– Future-year results

– Unanticipated circumstances


Future

• Cost sharing is not dead

• Companies with significant functions and substance outside the U.S. will still find cost sharing a powerful planning tool

• In today’s environment, cost sharing may be very attractive – Companies restructuring supply chains

– Repatriation of cash

– Low values

• More IRS scrutiny


About DeloitteDeloitte refers to one or more of Deloitte Touche Tohmatsu, a Swiss Verein, its member firms, and their respective subsidiaries and affiliates. Deloitte Touche Tohmatsu is an organization of member firms around the world devoted to excellence in providing professional services and advice, focused on client service through a global strategy executed locally in nearly 150 countries. With access to the deep intellectual capital of approximately 135,000 people worldwide, Deloitte delivers services in four professional areas—audit, tax, consulting, and financial advisory services—and serves more than one-half of the world’s largest companies, as well as large national enterprises, public institutions, locally important clients, and successful, fast-growing global growth companies. Services are not provided by the Deloitte Touche Tohmatsu Verein, and, for regulatory and other reasons, certain member firms do not provide services in all four professional areas.

As a Swiss Verein (association), neither Deloitte Touche Tohmatsu nor any of its member firms has any liability for each other’s acts or omissions. Each of the member firms is a separate and independent legal entity operating under the names “Deloitte,” “Deloitte & Touche,”“Deloitte Touche Tohmatsu,” or other related names.

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