Chapter 12 - Exploiting Intangibles
Choices for structuring these arrangements:
1) Independent licensing for royalty income.
2) Transfer of intangible property rights in an independent capital
3) Transfer of intangibles to a foreign corporation in Code
4) Cost sharing arrangement with related company.
5) Use of a foreign base company for licensing.
Definition of Intangibles
1) Patents, inventions, know-how.
3) Trademarks, tradenames.
4) Franchises, licenses, contracts.
5) Methods, programs, systems, procedures, customer lists,
6) Other similar items.
Reg. §1.482-4(b) & Code §936(h)(3)(B).
Licensing Intangibles to an Independent
1) International licensing enables royalties without a significant
2) Limited foreign country income tax usually incurred on an
outbound royalty payment.
3) Planning: Use royalties from unrelated licensees in
a licensing trade or business to enhance the amount in the general
limitation FTC basket.
See Code §904(d)(1)(B) (i.e., assumes that royalties are not
in the passive income basket).
Tax Incentives for Licensing Intangibles
Use no/low taxed royalties in a foreign country to average down
the foreign tax cost for purposes of being below the overall FTC limitation
amount (including under an income tax treaty).
Do royalties paid enable an income tax deduction to the payor in
the payor’s country?
This assumes the royalties will enable classification within the
general limitation FTC basket (under look-through rules).
Tax Treatment of Royalties in Source
Royalty payments are tax deductible in the licensee/payor's
Transfer pricing considerations apply in the payor's country under
either (i) the payor country's tax law, or (ii) an applicable bilateral tax
Licensor's tax treatment in source country?
1) Treaty - exemption or low withholding tax rate.
2) Statutory tax rules – possible tax withholding at source.
U.S. Income Tax Treatment of Royalty
For foreign tax credit purposes, are royalties received in the active
conduct of a trade or business? If so, then FTC general limitation
basket income: §904(d)(1)(B). Possible to absorb excess foreign tax
credits from taxes on operating income.
Otherwise, §904(d)(1)(A) passive basket income.
Therefore, a necessity for exploiting inventions generated through
the entity’s own research and development - to qualify for the active-business
U.S. Corp’s Patents
Comet regularly buys U.S. and foreign pharmaceutical
patents. Technical employees are responsible for commercialization
Licensing in the United States and abroad in return for royalties
equal to a specified percentage of the net sales by the licensees.
Source of royalties? U.S./foreign patents? Sourced to
country where the patent was issued.
What FTC limitation basket? A or Residual B? Derived
in active conduct of a trade or business?
Capital Gains Licensing
Transfer of “all substantial rights” as constituting a sale of (1)
a capital asset, or (2) a §1231 property (even when payment as a stream of
Therefore, eligibility for LTCG treatment (and the intangible
asset transferred is assumed to not be inventory sold by transferor).
Treatment under §§1221, 1231 or 1235 (to avoid ordinary income tax
& Trademarks & Goodwill
Patent as (1) a capital asset (§1221), or (2) a §1231 asset?
§1235 (p. 973) - deemed sale or exchange treatment – this
treatment is only applicable to individuals.
Patent as a monopoly grant - 20 (21?) years from date of the
A federal property law concept.
Possible U.S. tax amortization (§197) of the income tax basis by
the purchaser of this item.
Know-how is identified as “secret information” – enabling a right
to prevent unauthorized disclosure; a local law property concept. Can it be
a capital asset for capital gains licensing purposes?
Rev. Rul. 64-56 (p.1018) - foreign country where the transferee is
located must provide substantial legal protections against the
unauthorized disclosure of the know-how (to enable it to be categorized as “property”
for federal tax purposes).
Monopoly granted under federal law for 70+ years in the U.S.
Does a foreign law comparable exist?
No capital gains treatment if personal efforts of the holder created
the copyrighted work.
§§1221(a)(3)(A) and 1231(b)(1)(C).
See Reg. §1.861-18 concerning transfers of computer
programs. A copyright sale necessitates the transfer of all
Patent “Sale” Requirement
What is a “sale or exchange” of a patent?
1) Actual assignment (i.e., title transfer); or,
2) Exclusive “license” to use, manufacture and sell the
patented invention within a defined geographical area for the remaining life of
the patent. Legal title to the patent is retained by the licensor.
Assignment of all substantial rights to the patent can be
treated as a “sale” for U.S. income tax purposes.
“Sale” Requirement, cont.
Forms of Payment
Possible payment options enabling LTCG treatment upon a “sale”:
1) Single fixed payment.
2) Fixed installment payments.
3) Contingent royalty payments over a specified
period is permitted (useful life of the asset?)
Payment for ancillary services is permitted.
Retention of various controls over transferred asset
are permitted. Are external standards
Retained Patent Rights
(sale treatment permitted)
“Snap-back” provisions can be retained (where not within the transferor’s
control) & sale treatment:
2) Lack of productivity and, therefore, inadequate royalties to
3) Foreign country expropriation of the property;
4) Foreign exchange controls become applicable;
5) Veto right over sublicensing by transferee. Cf., right of
licensor to sublicense others in the licensee’s territory.
Functional subdivision of foreign patent rights.
Funds were received in exchange for an assignment of certain
Brazilian patents. Taxable as ordinary income or as capital gains?
Refund claim was based on capital gains status, after reporting
ordinary income. §1222 and §1231?
Conclusion: division of functional applications can be acceptable to enable “sale”
treatment for U.S. income tax purposes; here the value of the retained
patent rights is problematical.
1. Exclusive license to independent licensee.
License otherwise qualifies as a sale for tax purposes.
Tax effect of a right to terminate:
a) After license is in effect for ten years;
a transfer of all substantial rights, since not for 20 year life
of the patent (unless only 10 years left).
b) Exchange controls - beyond the control of the licensor - not
vitiating sale treatment. Cont.
c) Bankruptcy of the licensee - same as b.
d) Failure to reach production levels.
If the production levels are reasonably attainable, then not
within the control of the licensor, and imposing this condition is not
inconsistent with sale.
e) Failure to use "best efforts" to develop a
market. Best efforts is a subjective standard, but the licensor's
judgment on this issue would not be
f) Quality standards. This requirement is consistent with sale
status if the quality standards are appropriate and reasonably
g) Failure to supply the reasonable needs of the customers.
Not preventing the qualification of the license as being a sale for U.S. tax
h) Right to veto sublicensing. Veto over sublicensing is not
inconsistent with a sale.
Sales of “Know-how” and Trade
Value of know-how is dependent upon continuing secrecy and
not on existence of a govt. monopoly. DuPont case , No “sale”
here (retained right).
IRS says secret process was “property” but that no “sale”
occurred. Therefore, no preferential capital gains treatment &
ordinary income treatment.
Transfer of a trade secret may be equivalent to a
sale. Must transfer the right to prevent unauthorized disclosure
of the secret, but not occurring here.
Must be an enforceable right under local law.
Sales of Copyrights as
Business Profits? p.993
A copyright can be sold – including for royalty
payments (rather than for a lump sum).
Computer programs – many formats for the transfer of rights
1) Copyright transfer;
2) Transfer of a copy of the computer program;
3) Services for program use;
4) Know-how concerning programming.
Are all “substantial rights” being transferred?
Sale of Patent Rights to a Foreign
P. 995. IRC §1249 provides that gain realized on a patent,
etc., transfer to a foreign corporation controlled by the U.S.
transferor will be treated as ordinary income and not as capital
gain. Why? Relevant to individuals.
IRC §1249(b) - control means ownership, directly, indirectly or
constructively, of the stock of the foreign corporation possessing more than 50
percent of the total combined voting power of all voting classes of stock.
Transfers of Trademarks,
Tradenames & Franchises
Gain on the transfer of a trademark or tradename or franchise:
Ordinary income and not capital gain if the transferor retains any “significant
power, right or continuing interest” with respect to the transferred property.
See §1253(b)(2) providing a listing of what constitutes a “significant
power, right, or continuing interest” for this purpose.
Are computer software licenses to foreign licensees within
the scope of §1253?
Alternatively, are the related intangibles treated as transfers
separate from franchise transfer?
Holding: Franchises exist for §1253 purposes. The
transfers made were of the right to sell the programs. The taxpayer
retained significant rights.
Ordinary income was realized.
OID Issue - Sale for Stated Amount/No
Installment payments for intangible sales.
OID may be imputed - §1274 applies if the stated redemption price
exceeds imputed principal amount. When does this occur?
§1274 is inapplicable for less than $250,000 sales; but, §483
is then applicable and the result is essentially similar.
§1235(a) (individual) sales or exchanges of patent rights are not
subject to §1274 or §483 rules.
Source of Income Rules & Intangible
To the residence - where a fixed price sale.
§865(a) and (d)(1)(A).
Including when deferred.
Royalty source rule if the price is contingent on productivity. §862(a)(4). §865(d)(1)(B).
Depreciation recapture rule. §865(d)(4)(B).
Special sourcing rule for goodwill - source to the country
in which the goodwill was generated. §865(d)(3). How is goodwill sold?
Transfer of Intangibles in Exchange
for Stock p.1010
1. Cost basis of intangible property transferred is probably zero
- since §174 permits a current R&D deduction.
2. §351 precludes gain recognition on the transfer
of appreciated assets, if applicable:
- must transfer "property"
- transferors must have 80% control (as a group) in
§367(d) rules for
intangible property transfers p.1012
Transfer of intangibles to a foreign corporation:
a) no immediate income tax recognition.
b) but licensing treatment, as if sold to the transferee for
periodic (or contingent) payments.
c) full gain recognition if intangible is sold by the foreign
corporation after the transfer to the foreign corporation (or if the transferee
corp. stock is sold).
d) treated as ordinary income (even though a deemed
e) until TRA-97, also treated as U.S. source income.
Now treated as foreign source.
f) exception for foreign goodwill or going
concern value. Foreign based residual value of the business.
g) valuation problems – super-royalty provision, i.e.,
amount treated as received must be “commensurate with income.” P. 1014.
h) Foreign corp. E&P reduction is made for the deemed royalty
amount - §367(d)(2)(B)
Other §367(d) considerations:
- Use a sale/license rather than §351 for intangibles transfer
- Royalty is treated as an account
receivable under §367(d).
- Elect sale treatment? P.
1015. But, U.S. source ordinary income; Reg. §1.367(d)-1T(g)(2).
-Transfer to a partnership – see §367(d)(3)
(note the partnership tax rule in a Subchap. C §).
“Property” Requirement -
a Code §351 Element
Rev. Rul. 64-56 (p. 1018) - does “know-how” constitute “property”
for §351 purposes? Or, does it constitute services (& §351 is
To be “know-how” the country where the transferee operates must
afford the transferor substantial legal protection against the
unauthorized disclosure and use of the process, formula, or other secret
information involved. See Rev. Proc. 69-19, p.1021.
Note the representations to be made when seeking a tax ruling for
a know-how transfer/stock exchange.
“Property” Transfer Requirement -
A transfer must be made of "all substantial rights"
for a property transfer to occur for §351 purposes (& not only
partial rights, i.e., a license).
Ordinarily, the transfer of economic rights for intangibles
is accomplished by an exclusive license, rather than by a legal assignment.
Retention of certain controls and rights of recapture may be
acceptable for this purpose.
Royalty-free non-exclusive license (under French patent) to
sub to make, use & sell item in France.
Parent received stock as a result of this license.
Challenge re §351 & holding that §351 not having the
same concept as the capital gains provisions.
Capital gains contemplate completeness of disposition, but §351 is
based on control over the transferred rights. Held: Non-exclusive
license to the subsidiary was a § 351 “property” transfer.
Transfer as a “Contribution to Capital”
§367(c)(2) - contribution to corporation is treated as a
constructive exchange for §367 purposes.
If the transfer is made of an appreciated “intangible” - then this
transfer is subject to the further provisions of §367(d).
Base Company Licensing &
Headquarters Entity p.1030
Possible to get larger after-foreign tax profits in an offshore
licensing company (when compared to payments directly into the United States)?
Royalty paid is (ordinarily) permitted as a deduction for foreign
country payor tax purposes.
Generate low/no taxed royalty income to blend with high taxed
income (assuming general limitation basket income).
Applicability of Subpart F Rules –
Impact of Subpart F - not applicable if:
i) Related party/same country exception is available. §954(c)(3)(A),
ii) Exception is available when royalties are derived in the “active
conduct of a trade or business” and received from a non-related person.
Arm’s Length Pricing
Code §482 requires an arm’s length pricing treatment for transfers
of intangibles as applying to:
2) sales, and
3) contribution to transferee’s capital (with or without stock
being received in the exchange).
This includes the “commensurate with income” mandate.
Alternative Arm’s Length Pricing
1) comparable uncontrolled transaction(CUT)
2) comparable profit method (CPM)
3) profit split methods (PSM).
Subject to applicability of the “best method” approach.
Subject to periodic adjustments.
Alternative: possible cost-sharing agreement.
Drug B license with an independent as a comparable uncontrolled
transaction (CUT) for the controlled licenses of drugs A and C?
2) representing significant improvements;
3) expected to promptly reach high sales levels;
4) anticipated same average annual profits.
Cost Sharing Arrangements
Sharing by multiple parties of the costs and the risks for
developing intangible property in return for a property interest in that
Must have a method to calculate each controlled participant's
share of the intangible development costs - based on the anticipated benefits
to be received.
Cost sharing arrangement components – see p. 1056-7.
Buy-In and Buy-Out
What is a buy-in or buy-out arrangement?
Compensation must be provided for the contributor of any excess
value when implementing the cost-sharing arrangement.
Possible for IRS and taxpayer to negotiate and agree on the
specific future resolution of pricing issues for intangible (and other)
transfers to a related party (particularly a related foreign corporation).
See the Chapter 8 material.