Download Development, Ownership and Licensing of Intellectual

Taxation of Corporate Transactions/February–March 2004
Development, Ownership
and Licensing of Intellectual
and Intangible Properties—
Including Trademarks, Trade
Names and Franchises
By William P. Elliott
Bill Elliott discusses the development,
ownership and licensing of intellectual
and intangible properties. Included is a
discussion of the rules for determining
the source of different types of income
from intangible property, the tax regime
applicable to tax-free transfers of intangible
property and the Code Sec. 482 transfer
pricing rules.
Introduction
The United States asserts jurisdiction over international
intellectual property transfers by way of the principles for
taxing jurisdiction generally known as “domiciliary jurisdiction” and “source jurisdiction,” or simply “residence” and
“source.” Jurisdiction by residence is based on the status
of the taxpayer as a citizen, resident or entity organized or
managed in the jurisdiction, whereas source jurisdiction is
based on the source of income and, in the case of conflicting
claims, takes precedence over the concept of residence.
The United States asserts the jurisdiction of residence
over “persons” of the United States, including citizens and
©
2004 W.P. Elliott
William P. Elliott, CPA, ABV, CVA, LL.M., is a Domestic &
International Tax Partner at Decosimo CPAs in Chattanooga.
21
Intellectual and Intangible Properties
residents, domestically organized
corporations and partnerships,
and domestic trusts and estates
and accordingly taxes such persons on their worldwide income.
The United States asserts source
jurisdiction over foreign persons,
including nonresident aliens and
foreign corporations organized
abroad, and taxes them on their
source investment income on a
gross basis at a 30-percent gross
rate, and on certain U.S. source
business income “effectively
connected” with the conduct of
a trade or business in the United
States on a net basis at regular
graduated rates.1
Sections 861 through 865 of
the Internal Revenue Code (“the
Code”) furnish the rules for
determining source of income,
which are generally applicable,
for different reasons, to both
foreign persons and U.S. persons. For foreign persons, these
source rules govern the scope of
the United States’ exercise of its
source jurisdiction to tax certain
domestic source income of foreign
persons. For U.S. persons (over
whom the United States exerts
jurisdiction by residence to tax
worldwide income), these source
rules are primary factors incident
to the computation of the foreign
tax credit allowed by the Code to
mitigate or alleviate the potential
double tax on income asserted
by the United States and based
on a U.S. domicile, and taxed by
a foreign country and based on
the foreign source of the income.
Generally, both foreign and U.S.
persons prefer to characterize income as foreign source.2
Under Code Sec. 865, the
source of income from a transfer
of intellectual property is determined by the characterization of
the transaction as a sale for fixed
22
payments, a sale for contingent
payments, a sale of depreciable
personal property, a nonsale license or personal compensation.
I. Intellectual
Property Transfers
and Source of
Income
A. Source of Income Rules
The purpose of the source rules
is to assert the United States’
source jurisdiction to tax income
that has sufficient and reasonable
nexus with the United States. Two
convenient tests exist to establish
the necessary nexus to justify the
exercise of source jurisdiction:
Business activities test.
The business activities test
determines that the source
of income derives from the
country in which an income-producing activity is
conducted.
Utilization test. The utilization
test determines that the source
of income is from capital or
property. Thus, the source is
the country in which the capital or property is used.
These source rules, however, are
extremely broad and consequently
are not so practical to use in providing independent characterization
criteria for determining whether
an international intellectual property transfer should receive sale,
license, personal compensation
or other tax treatment. Inevitably,
one is forced to seek other guidance and resort to the Code for
other characterization rules that
can apply the source rules by
analogy, taking into account the
particular source rule and the
type of transaction. The IRS has
adopted a regulatory position that
a sale for purposes of the 30-percent gross tax on investment gains3
includes a Code Sec. 1235 sale or
exchange giving rise to capital
gains for patent transfers.4 Code
Sec. 865 (added by the 1986 Tax
Reform Act) determines the source
of income from sales of personal
property by reference to the residence of the seller as its general
rule,5 and Code Sec. 865(d)(1)(A)
applies to sales of intellectual
property for noncontingent or
fixed payments under the general
residence of the seller rule.6
B. “Fixed Payment” and
“Contingent” Sales
A sale for a fixed payment is perhaps the least common method for
transferring intellectual property,
since an owner of intellectual
property typically can maximize
the value of intellectual property
through licenses or sales with consideration contingent on the level
of exploitation or use of the property.7 The general rule regarding
the characterization of a sale for
source rule purposes is that a sale,
following patent sale principles
by analogy, requires the transfer
of all substantial and valuable
rights in the intellectual property
for the legal life of the intellectual
property. The sale versus license
characterization issue arises most
frequently in the patent area. In
general, under Code Sec. 1235, a
sale of a patent requires a transfer of all substantial rights in the
patent or an undivided interest in
such rights for the legal life of the
patent.8 The substantial rights in a
patent include the right to make,
use and sell the patent, and the
courts and the IRS have applied
the patent sale principles by analogy to copyrights, trade secrets,
know-how and trademarks.9
Taxation of Corporate Transactions/February–March 2004
The Code imposes a 30-percent
gross tax, subject to withholding
at source, on certain “fixed or
determinable annual or periodic”
investment income paid from U.S.
sources to nonresident aliens and
foreign corporations, which is not
effectively connected with the
conduct of a U.S. trade or business10 and which the Regulations
thereunder exclude from coverage
the income from sales of intellectual personal property for fixed
payments. 11 This consequently
renders the 30-percent gross
withholding tax to fixed payment
sales of intellectual property inapplicable. Further, assuming a
foreign person’s fixed payment sale
of intellectual property is not effectively connected with the conduct
of a U.S. trade or business, this sale
is exempt from tax, regardless of
the sourcing rules.
However, a foreign person’s
fixed payment sale of intellectual
property is effectively connected
with the conduct of a trade or
business in the United States and
is taxed on a net basis, accounting
for deductions, at regular rates under Code Sec. 871(b) or Code Sec.
882(a). An exception to the general residence of the seller source
rule for personal property sales exists under Code Sec. 865(d)(1)(B),
which determines the source of
contingent payments from the sale
of intellectual property as if such
payments were royalties, while
in turn Code Sec. 861(a)(4) and
Code Sec. 862(a)(4) determine the
source of royalties paid for the use
of intellectual property by place
of use, allowing the United States
to justify jurisdiction by source by
the assertion of sufficient nexus, as
the country where the property is
used or exploited is the strongest
source for taxing such intellectual
property income.
The Code also imposes a 30percent gross tax, subject to
withholding at source, on the gain
component of U.S. source contingent payment sales of intellectual
property, paid to nonresident alien
individuals and foreign corporations, and which is not effectively
connected with the conduct
of a U.S. trade or business. If
the source of a foreign person’s
contingent payment sale of intellectual property is the United
States and is effectively connected
with the conduct of a U.S. trade
or business, then the Code taxes
it on a net basis at regular rates.12
The Treasury regulations governing the 30-percent gross tax on
investment gains from contingent
payment sales of intellectual property contain a unique regime for
basis recovery, whereby full basis recovery is allowed from the
earliest payments received prior
to taxing the gain element of
U.S. source contingent payments
from such sales.13 This immediate
basis recovery method differs significantly from the basis recovery
methods that the IRS requires for
contingent payments reported under the installment method with
the net effect that gain recognition
is accelerated for such contingent
installment payments by treating
only a portion of each payment
received as basis recovery.
C. Depreciable/Amortizable
Property
In another exception to the general residence of the seller source
rule for sales of personal property,
Code Sec. 865(c) also determines
the source of gains from the sale
of depreciable personal property
to the extent of prior depreciation adjustments, pursuant to a
recapture matching principle. In
particular, Code Sec. 865(c)(1)
places the source of such gains,
to the extent of prior depreciation
adjustments, by reference to the
source of income (U.S. source
or foreign source), against which
the sellers offset the depreciation giving rise to the gain. Thus,
gains arising from depreciation
that offset U.S. source income
generate U.S. source gains. Correspondingly, gains arising from
depreciation that offset foreign
source income generate foreign
source gains. Code Sec. 865(c)(2)
places the source of gains from
the sale of depreciable personal
property in excess of such prior
depreciation adjustments under
the place of title passage rules
applicable to inventory. In analyzing the potential application of
the Code Sec. 865(c) depreciation
recapture rule to intellectual property, the extent to which different
types of intellectual property
are depreciable should be considered. In general, Code Sec.
167 authorizes depreciation of
those intangible assets that have
a limited useful life, which can
be estimated with reasonable
accuracy.14 Thus, patents are depreciable under Code Sec. 167 at
least over their 17-year legal lives,
or, in the case of design patents,
their 14-year legal lives. Similarly,
copyrights are depreciable at least
over their legal lives,15 with trade
secrets and trademarks generally
being ineligible for depreciation
because they have theoretically
unlimited useful lives.
In the case of fixed payment
sales of intellectual property by
a foreign person not effectively
connected with the conduct of
a U.S. trade or business, the application of the Code Sec. 865(c)
recapture principle has no tax effect. The Code exempts such sales
from tax, whether U.S. source or
23
Intellectual and Intangible Properties
foreign source, because they have
an insufficiently high net income
content. Contingent payment
sales of intellectual property by
a foreign person not effectively
connected with the conduct of a
U.S. trade or business create foreign source income that is exempt
from tax since, absent a U.S. trade
or business, depreciation generating gain from such sales probably
will be offset by foreign source
income.16
In the case of sales of intellectual property by foreign persons
effectively connected with the
conduct of a U.S. trade or business, the application of the Code
Sec. 865(c) recapture principle
creates U.S. source business
income taxed on a net basis for
gains attributable to that depreciation offsetting U.S. source
business income. Finally, in the
case of U.S. persons, the application of this recapture principle
to sales of intellectual property
creates U.S. source income that
has no foreign tax credit benefit
for gains attributable to that depreciation offsetting U.S. source
income, even if the person sells
the property exclusively for use
abroad in circumstances that
would otherwise generate foreign
source income under Code Sec.
865(d).17
D. Property Sales Source Rule
May Govern
Code Sec. 865(e)(2), enacted
as part of the 1986 Tax Reform
Act, is perhaps the single most
important personal “property
sale source rule” applicable to
foreign persons, as it overrides
the Code Sec. 865(a) general
residence of the seller rule, the
Code Sec. 865(b) inventory place
of title passage rule, the Code Sec.
865(c) depreciation recapture rule
24
and the Code Sec. 865(d) intellectual property rules. Further, it
determines the source to be U.S.
when any income from the sale
of personal property, including intellectual property and inventory
property, is attributable to a fixed
place of business maintained in
the United States,18 which “office”
is, in and of itself, a material factor
in the production of income.19
Thus, in analyzing the source
of income from any transfer of
intellectual property having international aspects, one should first
determine whether any of these
overriding source rules apply to
determine the source.
II. Transfers
of Intangible
Assets20 Between
“Associated
Enterprises”21
A. Assessment of Royalty
or “Super Royalty”?
The Code imposes special rules
on certain transfers of intellectual
property by/between related persons who are subject to special
rules that limit the ability of U.S.
persons, in an effort to avoid
current taxation and obtain tax
deferral or effective tax exemption
for income attributable to intellectual property, to shift income to
foreign entities that are exempt
from U.S. taxation.
Code Sec. 367(d) “recharacterizes” contributions of intellectual
property by U.S. persons to the
capital of foreign corporations in
otherwise nonrecognition transactions under Code Sec. 351 or
Code Sec. 361 as deemed sales,
creating deemed annual royalties.
Additionally, Code Sec. 482 cre-
ates so-called “super royalties” on
transfers, sales or licenses of intellectual property between related
parties and requires the allocation
of such royalties to the transferor
in an amount equivalent with the
income attributable to such intellectual property. The principal
difference between a Code Sec.
367(d) deemed royalty and a Code
Sec. 482 deemed royalty is that
the former automatically creates
U.S.-source income22 while the
latter creates income determined
by the place of use of such intellectual property under the general
source rules.23
Capital contributions of intellectual property by U.S. persons to
foreign corporations in otherwise
nonrecognition transactions under
Code Sec. 351 or Code Sec. 361
are recharacterized under Code
Sec. 367(d) as “taxable contingent
payment sales,” creating “deemed
annual royalties” over the useful
life of the contributed property.
Further is the requirement, harsh
though it may be, that Code Sec.
367(d) incorporates the super royalty concept24 and is applicable
to contributions of “intangible
property,” defined broadly to include any:
patent, invention, formula,
process, design, pattern or
know-how;
copyright, literary, musical or
artistic composition;
trademark, trade name or
brand name;
franchise, license or contract;
method, program, system,
procedure, campaign, survey, study, forecast, estimate,
customer list or technical
data; or
any similar item that has substantial value independent of
the services of any individual
Taxation of Corporate Transactions/February–March 2004
but excludes goodwill and going concern value.25
Notably, Code Sec. 367(d) is not
applicable to certain copyrights
and similar property produced
by a taxpayer’s personal efforts
described in Code Sec. 1221(3),
as such property is a “tainted”
asset, and any “built-in gain” is
taxed immediately under Code
Sec. 367(a) upon contribution to
a controlled foreign corporation
rather than taxed annually under Code Sec. 367(d).26 Further,
Treasury Regulations provide that
Code Sec. 367(d), rather than
Code Sec. 482, applies to a U.S.
person’s transfer of intellectual
property to a related foreign corporation without consideration.
The “hypothetical” royalty
assumes a taxable sale of the intellectual property to the controlled
foreign corporation (CFC) in return
for a contingent royalty payable annually over the useful life of the
intellectual property and “joined
at the hip” to the income from the
property. The tax consequences of
the deemed receipt of annual U.S.
“source deemed super royalty” income under Code Sec. 367(d) are
extremely harsh; its practical effect
is to force multinational enterprises
(MNEs) to license or sell their intellectual property, even if to related
parties subject to recharacaterization under Code Sec. 482, in an
effort to avoid the adverse consequences of an encounter with
brutal outbound consequences of
Code Sec. 367(d).
B. Super Royalty Provision and
Code Sec. 482
The super royalty provision of
Code Sec. 482 provides that, in
the case of any transfer or license
of intangible property, “the income
with respect to such transfer or
license shall be commensurate
Illustration 1
The principal difference between a Code Sec. 367(d) deemed royalty
and a Code Sec. 482 deemed royalty is that:
■ A Code Sec. 367(d) deemed royalty automatically creates U.S. source
income, and
■ A Code Sec. 482 deemed royalty creates income determined by the
place of use of such intellectual property under the general source
rules.
U.S.Source
Income
Code Sec. 367(d)
Deemed
Royalty
Source
=
Place of use
TRANSFERS OF INTANGIBLE ASSETS
BETWEEN “ASSOCIATED
ENTERPRISES”
with the income attributable to
the intangible.” Effectively, this
recharacterizes related party
transactions on an arm’s-length
basis,27 and creates a problem
with respect to the valuation of
intellectual property by mandating
that “cost-plus” contract manufac-
Code Sec. 482
Deemed
Royalty
turer relationships between related
parties will be deemed to constitute an ineffective assignment
of income by the transferor. By
further mandating a “look-back”
requirement, the super royalty
provision requires “transactional
maintenance” by necessitating a
Illustration 2 Transfers of Intangible Assets Between
“Associated Enterprises”
Code Sec. 367(d) “recharacterizes” contributions of intellectual
property by U.S.persons to foreign corporations in otherwise
nonrecognition transactions under Code Sec. 351 or Code Sec. 361
as deemed sales creating deemed annual royalties.
DEEMED ROYALTY
U.S.
Person
INTELLECTUAL
PROPERTY
Foreign
Corporation
DEEMED
SUPER-ROYALTY
Related
Party
Additionally, Code Sec. 482 creates so-called "super royalties" on transfers, sales
or licenses of intellectual property between related parties and requires the allocation
of such royalties to the transferor in an amount equivalent with the ncome attributable to it.
25
Intellectual and Intangible Properties
continuous “re-evaluation” of the
adequacy of intellectual property
royalties in related party transactions. And to complicate matters
further, the super royalty provision
turns on whether such intellectual
property is in existence or owned
by the sale.
Thus, in inbound licensing
transactions, a foreign licensor’s
royalty income generally will
constitute U.S.-source income
under the place of use rule, subject to a 30-percent gross tax. For
outbound international transactions, a U.S. person should never
contribute intellectual property to
the capital of a controlled foreign
corporation in a Code Sec. 351
or Code Sec. 361 nonrecognition
transaction that triggers the harsh
rules of Code Sec. 367(d). Further,
the potential adverse effects of the
Code Sec. 482 super royalty provision should be evaluated before
transferring intellectual property
to related foreign entities. Alternately, the Code Sec. 482 super
royalty provision can serve to
mitigate adverse tax effects by, for
example, having a foreign affiliate
develop or purchase intellectual
property directly and then sell or
license such property back to the
U.S. parent corporation in such
a way that any Code Sec. 482
allocation will constitute foreign
source income to the foreign subsidiary transferor.
III. Transfers of
U.S.-Based
Intellectual Property
to Related Entities
A. Background
As discussed in the preceding section, a person owning intangible
26
property may transfer ownership
or use to a related person by
means of:
a sale;
a license;
an exchange for an ownership
interest (e.g., stock of the related person);
a contribution (e.g., a capital
contribution to the related
person); or
an exchange for other property (e.g., a swap of rights
under one patent for rights
under another patent).
If the related person is a foreign
corporation,28 then each of these
transfers has the potential for shifting future income to an entity that
pays no (or limited) U.S. taxes,
while at the same time, a transfer
by foreign persons to a controlled
U.S. corporation has the potential
for draining income from that corporation in the form of excessive
royalties. Two primary Code sections limit the shifting of income
through the transfer or licensing of
intangibles. Code Sec. 482 generally applies to a sale or license to
a controlled entity, and Code Sec.
367(d) generally applies to (1) an
exchange by a U.S. person for foreign stock that would otherwise
qualify under Code Sec. 351 or
(2) a capital contribution to an
80-percent controlled foreign
corporation. 29 If a transaction
takes the form of an actual sale
or license by a U.S. person to a
related foreign corporation, then
Code Sec. 482 applies, and Code
Sec. 367(d) will not apply unless
the sale or license is a sham, with
the form chosen by the taxpayer
often controlling which set of rules
applies.
B. License vs. Sale
Differentiating a sale from a
license for federal income tax de-
pends on the extent to which the
transferor maintains proprietary
rights in the underlying property
after the transfer is completed,
with the greater the transferor’s ongoing dominion and control over
the property, the less likely the
classification as a sale. Of course,
classification as a sale means basis
recovery and capital gains instead
of ordinary income, at least with
respect to any gain attributable to
lump sum or other, fixed consideration. Alternately, classification of
the transfer as a license results in
ordinary income to the transferor
and precludes basis recovery on
the transfer, although the license
classification does defer the recognition of proceeds received for
the use of its property. Of course,
this issue has little or no impact on
the tax treatment of the transferee,
whose cost recovery of the consideration paid for the property
depends mainly on whether such
consideration is fixed or contingent. Fixed payments made by the
transferee are amortizable over a
15-year period, whereas contingent consideration generally is
deductible currently.
Congress early remedied historical confusion over the transfer of
certain intangible assets, namely
franchises, trademarks and trade
names, in enacting Code Sec.
1253 as part of the Tax Reform
Act of 1969.30 As enacted, Code
Sec. 1253 sets forth two rules
applicable to the transferor, the
first providing that a transfer of
a franchise, trademark or trade
name does not constitute “a sale
or exchange of a capital asset if
the transferor retains any significant power, right or continuing
interest with respect to the subject
matter of the franchise, trademark
or trade name.”31 Such a significant power, right or continuing
Taxation of Corporate Transactions/February–March 2004
interest for this purpose includes
the right to:
disapprove any assignment of
the transferred interest in the
property or any part of such
interest;
terminate the agreement at
will;
prescribe quality standards
for products used or sold and
services rendered; and,
for the equipment and facilities used to promote such
products or services, require
the transferee to:
sell or advertise only
products or services of
the transferor, and
buy substantially all its
supplies and equipment
from the transferor, or
receive payments contingent on the productivity,
use or disposition of the
subject matter of the property interests transferred, if
such payments represent a
substantial element of the
transfer agreement.32
The second rule, which applies
to transferors, involves contingent
consideration. As such, the transferor is deemed to have received
such consideration “from the sale
or other disposition of property
which is not a capital asset.”33
Fixed consideration can trigger
either ordinary income or capital
gains. Fixed consideration for this
purpose means any consideration
not measured with reference to
the subsequent use, productivity
or disposition of the transferred
property. It can take the form of a
lump-sum payment at closing, or
it can be a series of fixed amounts
to be paid over time.
C. Early Case Law
and Legislative History
Since the enactment of Code
Sec. 1253, one particular case
has highlighted the ambiguous
nature of the statute. In Tomerlin Trust, 34 the U.S. Tax Court
questioned the scope of Code
Sec. 1253 by reverting to prior
case law to resolve a sale versus
license question. The ambiguity
of the statute coupled with the
decision in Tomerlin Trust renders
the legislative history significant
in addressing the federal income
tax treatment of franchise, trademark and trade name agreements,
as its considerable discussion is
indicative of the confusion that
existed in the courts. Prior to the
Illustration 3 License vs. Sale
Differentiating a sale from a license for federal income tax turns on the
extent to which the transferor maintains proprietary rights in the
underlying property after the transfer is completed:
TRANSFEROR
PATENT
TRANSFEREE
LICENSE &
ROYALTY
The greater the transferor's ongoing dominion and control over the
property, the less likely the classification as a sale.
enactment of Code Sec. 1253,
state law was already in disarray as evidenced by a series of
five appellate cases dealing with
transfers of franchise rights,35 with
each of these cases having similar
fact patterns and each involving
the transfer of long-term and
territorially exclusive franchise
rights, fixed and contingent consideration, and the transferor’s
retention of rights as to quality
control and other matters.
In the first of these cases, the
Tenth Circuit ruled that the
transfer was a sale regarding
both lump-sum and contingent
payments, and further found the
rights retained by the transferor,
such as quality control, store
design, financial audit, control
over transferee’s supply and termination of the agreement, to be
conditions subsequently designed
to protect the rights of each party.
Accordingly, the court found that
such rights did not reserve for
the transferor an ongoing, proprietary interest in the franchise
transferred. In the second case,
the Fourth Circuit ruled that the
transfer was a sale and that the
lump-sum consideration was
an amount realized, but treated
the contingent consideration as
royalties, emphasizing that the
transferee’s rights were perpetual
and that that certain restrictions on
quality control and on the transferee’s product line protected the
product and brand name. However, these limitations did not give
the transferor a substantial right in
the property transferred.
The third case involved two
sets of contracts, and, therein,
the Fifth Circuit emphasized the
perpetual and exclusive nature of
the transferee’s rights, and ruled
that each set of contracts resulted
in a sale, at least with respect to
27
Intellectual and Intangible Properties
the lump-sum consideration paid
at closing.36 The fourth case had
identical facts as, and involved the
less fortunate brother of the transferor in, the Fifth Circuit decision,
but went before the Ninth Circuit,
which was in accord in part and
disaccord in part with the Fifth
Circuit. The Ninth Circuit found
rights retained by the transferor
in one type of contract to be only
protective in nature and therefore
insufficient to prevent sale classification.37 In the final Dairy Queen
case, the Eighth Circuit ruled that
the transfer was a license with respect to all consideration.38
Thus, five different Dairy Queen
cases on relatively similar facts
produced a split of authority: the
enactment of Code Sec. 1253, the
exclusive means for determining
whether the transfer is a sale or
license for federal income tax
purposes.
Since Tomerlin Trust, however,
the Tax Court has relied on and
applied Code Sec. 1253 to evaluate rights retained by transferors.
Stokely USA, Inc.39 involved a
trademark transfer agreement
under which the taxpayer paid a
lump sum in exchange for an interest in Stokely’s, Stokely’s Finest
and other trademarks for perpetual
use in marketing and selling food
products in certain locations. The
taxpayer’s use of the trademarks
was nonexclusive in some jurisdictions, and the taxpayer could not
use the trademarks on any porkand-beans products for 20 years.
The transferor could disapprove
any assignment of the taxpayer’s
interest in the trademarks for five
years. The court in Stokely stated
that Congress sought to enact a
“simple, uniform method” for determining the tax treatment of the
transfer of a franchise, trademark
or trade name and accordingly
28
rules as such to cite Code Sec.
1253 and the legislative history,
not prior case law, in determining whether rights retained by the
transferor were significant.
Nabisco Brands, Inc.40 involved
an agreement for the transfer of
Life Savers and other trademarks.
Under the agreement, the taxpayer paid a lump sum at closing
and agreed to make annual payments for 10 years based on a
fixed minimum and then on the
amount of sales attributable to the
trademarks. As it did in Stokely,
the Tax Court in Nabisco went
directly to Code Sec. 1253 to determine whether the transferor’s
retained rights and interests in
the property were significant and
did not apply pre-Code Sec. 1253
case law in this regard. Other
courts have read Code Sec. 1253
as having replaced prior common
law on the sale versus license and
related issues, as the Fifth Circuit
did in Resorts International.41 In
this case, the Fifth Circuit stated
that Congress intended Code Sec.
1253 to be the definitive test of
sale versus license classification.
In Consolidated Foods, 42 the
Seventh Circuit stated that Congress enacted Code Sec. 1253 to
provide uniform treatment of the
issue.
Although regulatory pronouncements by the Treasury have not
been consistent, the IRS has
consistently applied the statute
as the sole source of authority
for ruling on the tax effect of the
transfer of franchises, trademarks
and trade names, promulgating
numerous administrative rulings
in this regard. In its rulings, the
IRS apparently has not reverted to
pre-Code Sec. 1253 case law.43
Thus, based on the legislative
history, case law and administrative pronouncements, it would
seem prudent reasoning to view
Code Sec. 1253 as the sole authority for determining whether the
transfer of a franchise, trademark
or trade name is a sale or a license.
Further is Congress’ reasoning
that the transferor’s retention of
significant rights in the property
is inconsistent with sale treatment
and serves to classify the transfer
as a license.44
D. Tax Treatment of Transfers
with and Without Retention of
“Significant Rights”
Where the transferor retains a
significant right, the transaction
generally is treated as a license
and not as a sale of an ordinaryincome asset. The transferor’s tax
treatment on the grant of a franchise, trademark or trade name
depends on the extent of the rights
it retains in the underlying property, such that if the transferor retains
significant rights, the transfer
should not be a sale; it should be
a license. Assuming the transferor
of a franchise, trademark or trade
name does not retain a significant
right, the transfer should be a sale,
with the transferor computing gain
or loss under Code Sec. 1001. The
fixed or contingent nature of the
consideration could be a distinguishing factor in the treatment
of the transferor, as with respect
to contingent consideration, the
transferor is deemed under Code
Sec. 1253(c) to have received
amounts from the sale or other
disposition of property that is not
a capital asset, thus ensuring that
ordinary income and not capital
gains rates apply to contingent
consideration. As most transferors have no adjusted basis for tax
purposes in the transferred property either because the property
is self-developed or because the
transferor succeeded to its prop-
Taxation of Corporate Transactions/February–March 2004
erty rights by way of a license in
the first place, for such transferors
with tax basis in the property, the
issue becomes one primarily of
basis recovery.
If sale treatment extends to this
portion of the transaction, then the
contingent payments are includable in the transferor’s amount
realized for purposes of installment method calculations, which
defers the transferor’s recovery of
its tax basis in the property, perhaps materially. Alternatively, if
license treatment applies to this
portion of the transaction, the
contingent payments would be
royalties and the transferor would
have no basis recovery but would
recognize this income over time
as it earns the payments under the
terms of the transfer agreement.
Finally, as to the transferee, two
major rules provide for a fairly
clear determination of the cost
recovery of the consideration
paid for the franchise, trademark
or trade name, as the transferee’s
tax treatment does not depend
directly on the sale versus license
classification but rather on the
fixed or contingent nature of its
payments. Contingent consideration45 typically is deductible in
full, while lump sum and other,
fixed consideration generally is
chargeable to capital account and
is amortizable by the transferee
over a 15-year period.46
In regards to the right to receive
contingent payments (Code Sec.
1253(b)(2)(F)), the amount of
such payments relative to total
consideration must be substantial
in order to avoid sale treatment.
Based on the Tax Court’s decision
in Nabisco Brands, 25 percent of
the total consideration received
should be a good barometer in
this regard. As to retained rights
not specifically listed in Code Sec.
1253(b)(2), the issue turns to their
materiality and value: the greater
the materiality and value of such
rights, the greater the likelihood
of classifying the transfer as a
license and not a sale. Finally,
the extent or total number of
rights retained by the transferor
is important, as only one right
falling within the requirements of
Code Sec. 1253(a) or Code Sec.
1253(b)(2) should be sufficient
to trigger license treatment, as
no equitable, de minimus-type
exception should prevent a transaction from being a license simply
because the transferor retains only
one significant right. A transferor
desiring sale treatment must limit
its retained interest accordingly,
and it would seem worthwhile to
include in the transfer agreement
several rights listed in Code Sec.
1253(b)(2), especially where one
of the potentially significant retained rights is the right to receive
contingent payments, because the
parties may not be able to project
with high probability whether
the ultimate amount of contingent payments will be substantial
relative to total consideration.
IV. MNEs47 and
the Development,
Ownership and
Licensing of
Trademarks and
Trade Names
A. Introduction
In a period where the prices
that companies can charge for
their goods and services are
permanently under pressure, it
appears that only companies that
have valuable intangibles can
actually offer unique products
and services and thus escape
the continuing process of price
erosion. This explains why large
companies in particular perform
much better financially: They appear to be the preeminent owners
of distinctive intangibles, particularly strong brand names, with the
rapidly increasing significance of
trademarks and other intangibles
giving rise to the necessity or desirability of including the value
of trademarks developed by a
company itself in that company’s
annual accounts. A trademark’s
commercial exploitation on an
international scale obviously
has major cost advantages, as
international groups are ideally
positioned to develop and exploit trademarks in a regional or
global context and can introduce
a successful trademark that was
developed locally in other markets. In various countries, the
financial significance of trademarks to trade and industry, and
in particular the above-described
tendency towards the development and use of trademarks on a
regional or even global scale, has
led to detailed tax rules, including the U.S. transfer pricing rules
and the OECD transfer pricing
guidelines.
B. Marketing Intangibles
The OECD Guidelines divide
“commercial intangibles” into
two main categories: “trade intangibles,” often created through
costly and risky technological research and development activities,
and “marketing intangibles.”48 The
Guidelines describe the concept
of “trademark”:
A trademark is a unique
name, symbol or picture
that the owner or licensee
29
Intellectual and Intangible Properties
may use to identify special
products or services of a particular manufacturer or dealer
and, as a corollary, to prohibit
their use by other parties for
similar purposes under the
protection of domestic or
international law.
As the OECD Guidelines note, the
exclusive position with regard to
the use of a trademark is to be
distinguished from the monopoly
position that is created for the
owner of a patent:
Patents may create a monopoly in certain products or
services whereas trademarks
alone do not, because competitors may be able to sell
the same or similar products
so long as they use different
distinctive signs.49
A trade name or group name
can be at least as valuable for
the sale of goods and services
as a trademark and sometimes,
such trade name or group name
is not also used as a service or
product mark, although the use
of the group name may bring a
group company major advantages
that justify a fee and necessitate
protection against the use by
others. It is not clear why such
a good (the name of a reputable
group) should be made available
to newly incorporated group
companies for no consideration;
however, emphasis should be on
whether a value-adding good is
being made available and not on
whether such a good may be given
in use outside the group context.
The OECD Guidelines stress the
importance of the availability of
a specific service to certain group
companies; it is quite likely that
in many instances an unrelated
30
party would be willing to pay a
fee, even if it could gain only an
incidental benefit from a service
provided directly to a third party.
Another category consists of
group names that are also used as
trademarks for the group’s products and services. Under this view,
there is no room for a fee for the
use of the group name/mark if the
trade name laws offer protection
against infringements, but such an
approach does not promote an
economically responsible manner of profit allocation within the
group A fast-growing, in-between
category is one in which the group
name is used besides the specific
service or product trademark not
only with the specific product
mark, but also to feature prominently the group name, perhaps
as a “seal of guarantee for quality.” The responsibility thus taken
by the group for the quality of
its brand-named products is extremely important to the group
company/licensee concerned
about the positioning of the products in relation to other products,
with the group name being used as
a general trademark name besides
the trademark name attached to
the specific product.
As with all intellectual property
rights, the object of ownership (the
trademark) is a creation of the law
of the state concerned, which creates an exclusive position for the
qualifying applicant through registration of the trademark, meaning
that use and exploitation of the
idea or concept is granted to it exclusively. Without the recognition,
and more importantly the statutory protection of the trademark
in a state’s legal system, there is
no ownership and thus no value,
and, due to the inseparable tie
between the intellectual property
law of a certain state and a trade-
mark, there may be several owners
of a single trademark in different
jurisdictions. The group company
that lawfully registers a trademark
in the relevant jurisdiction should
be regarded as the legal owner of
a trademark. From a strictly legal perspective, the granting of
a royalty-free, exclusive, freely
transferable, “perpetual” license
to a local group company does
not make the licensee the “owner”
of the trademark. Finally, under
the laws of most countries, the
trademark holder is permitted to
transfer a trademark separately
from the transfer of the operating business whose products or
services were protected by the
trademark.50 In some jurisdictions,
major trademark law impediments
may interfere with the centralization of ownership of trademarks
within the group.51
Naturally, a party other than
the legal owner of a trademark
may acquire an interest in that
trademark that represents a value
to it. A licensee, for example,
may acquire rights in relation to
a trademark that are so extensive
that the licensee can be regarded
as the “beneficial owner” (or “tax
owner”) of a trademark in a certain jurisdiction. The content, and
in particular the meaning, of the
concept varies with each jurisdiction, and to this end, the licensee
must acquire the exclusive right to
use a trademark in a jurisdiction
during a period that (almost) coincides with the expected economic
life of the trademark. The form of
the fee is not necessarily decisive
as a fixed sum that is periodically
due, for the term of the license
need not interfere with the transfer
of the beneficial ownership. On
the other hand, a once-only fee
for a short-term license will fail
to effect the transfer of beneficial
Taxation of Corporate Transactions/February–March 2004
ownership. Beneficial ownership
is involved if the licensee has acquired virtually all of the rights to
a trademark, and the legal ownership remains with the licensor
only to secure the one-time or
fixed periodic fee (purchase price)
payable by the licensee. The retention of legal ownership that does
not serve as security for the vendor, but enables him, for example,
to influence the licensee’s behavior, often will not result in the
licensee’s beneficial ownership
of the trademark. There is a very
wide range of conditions subject
to which a licensee, in different
degrees, can acquire an interest in
a trademark from the legal owner
or from third parties without such
an interest being equated with
beneficial ownership of the trademark, and this does not affect the
possibility that the acquired rights
must be regarded as a capital asset by the licensee, it also being
possible that the licensee itself
makes substantial investments
in the further development of a
trademark
Trademark licenses represent
the permission to perform certain acts with regard to a certain
trademark and generally fall into
the categories of (1) an exploitation license and franchising, (2)
a usage license or (3) a distribution license. If the owner of the
trademark is also the seller of the
products (the usage and distribution license), the question arises
whether the fee for usage of the
trademark must be included in
the price of the products or can
be paid separately, as a royalty,
but, from the perspective of profit
allocation, the only relevant point
is that the fee is paid once. With a
usage license, the licensee often
will pay the fee separately, and
with a distribution license, the
fee often will be included in the
price of the goods supplied. The
guidelines do not appear to be
relevant to trademark licenses, as
the trademark itself is irrelevant or
hardly relevant to the manufacturing of the goods and fulfills its role
only when the finished goods are
marketed, and, generally speaking, the arm’s-length principle’s
only consequence can be that a
separate fee from the licensee for
the use of the trademark must be
possible. In that event, the price
of the goods supplied must equal
that of unbranded goods.
C. Current U.S. Regulations/
OECD Guidelines
The regulations are based on
the predominant importance of
the legal ownership of the mark,
with the final regulations adopting a modified approach to the
identification of the owner of an
intangible that is more consistent
with legal ownership. Under
the legal ownership, the right to
exploit an intangible will be considered the owner for purposes of
Code Sec. 482,52 but “legal owner
of a right to exploit an intangible”
does not refer exclusively to the
legal owner of the trademark.53
The regulations, while attributing
the interest in the value development of the trademark to the legal
owner, apply a special definition
of “legal ownership,” as the legal
owner of a right to exploit an
intangible ordinarily will be considered the owner for purposes of
this section. Such legal ownership
may be acquired by operation of
law or by contract under which
the legal owner transfers all or part
of its right to another.54 The regulations’ most important conclusion
is that not even the acquisition of
a substantial part of the relevant
rights makes the licensee the own-
er of the trademark, as transfer of
the ownership of the trademark to
the licensee should be involved,
at least for tax purposes, only if
the licensee acquired nearly all of
the essential rights for the market
in question.55
In 1996, the OECD published
new guidelines that specifically
deal with the situation where a
licensee pays the costs involved
in the promotion (marketing) of a
trademark (or a trade name) on the
local market and further raise the
question whether the “marketer”
(licensee) should receive a fee as
a provider of services or should
be entitled to a portion of “any
additional return attributable to
the marketing intangibles.” The
Guidelines direct that the rights
and the obligations of both the
owner of the trademark and the
“marketer” should be considered.56
The implicit position of the OECD
Guidelines is precisely that, under
arm’s-length conditions, a licensor will not be prepared to grant
the licensee “(co-)ownership” of
the trademark, to the effect that
the licensee acquires a right to a
share in the value development of
the trademark itself on termination of the license. The unrelated
licensee will, however, ensure that
the conditions subject to which it
undertakes promotional activities
for its own account and risk are
such that it can expect a reasonable return on its investments. In
such a situation, the relevance of
the often long-term license right
for the licensee cannot be held to
be equal to (co-)ownership of the
trademark.
The U.S. transfer pricing regulations, as a consequence of the
importance of the legal ownership
of the intangibles, demonstrate a
clear tendency towards the acceptance of the contractual (license)
31
Intellectual and Intangible Properties
Illustration 4 The Arm’s-Length Principle
The arm's-length principle requires the existence of an assumed balance
between the:
RIGHTS
OBLIGATIONS
TRANSFEROR
BALANCE OF RIGHTS
& OBLIGATIONS
TRANSFEREE
The licensee will be prepared to bear substantial marketing and promotional costs (that may
increase the value of the trademark) only if the agreement includes conditions such that it will be
able to profit from the investments that it made, with a combination of conditions regarding the
use of the trademark (exclusivity, term, amount of the royalty fee) and the purchase price of
brand-named products enabling the licensee to do so.
relation that is created within
a group among the owners of
trademarks and licensees. The
underlying principle is that the
legal ownership of the trademark
is acknowledged as governing
for tax consequences, but “legal
owners” includes a category of
licensees that have only limited
rights of use to the trademark. The
OECD Guidelines, issued after the
Code Sec. 482 final regulations,
fully acknowledge that the fiscal
ownership of the trademark is with
the legal owner unless, it is assumed, all of the essential rights to
a trademark in a jurisdiction were
transferred to the licensee.57
The arm’s-length principle
requires the existence of an assumed balance between the rights
and obligations of the two parties
on the conclusion of the license
agreement. The licensee will
be prepared to bear substantial
marketing and promotional costs
(that may increase the value of the
trademark), only if the agreement
includes conditions such that it
will be able to profit from the
investments that it made, with
a combination of conditions re-
32
garding the use of the trademark
(exclusivity, term, amount of the
royalty fee) and the purchase price
of brand-named products enabling
the licensee to do so.58 The entire
complex of the contractual conditions must be considered. First,
it must be investigated whether
a possibly deviating provision is
compensated by another contractual provision. For example, the
marketing costs that are borne by
the licensee can be compensated
by contractual provisions, such as
a relatively low royalty. If no arm’slength balance exists within the
entire complex of rights and obligations, then an adjustment must
be sought within the framework of
the existing contractual relation,
with such conditions adjusted for
and established on a case-by-case
basis.
A trademark can have value
without being known in the territory of the licensee at the time that
the license is granted, and a trademark may have proven elsewhere
that it fulfils a valuable communication and identification function.
It is then very possible that the
concept on which the trademark
is based also can be successfully
launched in a new market. One
of the typical characteristics of
MNEs is that they are able to exploit sound ideas throughout the
world, irrespective of where those
ideas originally were developed,
although this in and of itself does
not diminish the fact that whether
the trademark in question has value for the market of the licensee
must be established at the time
that the license is granted.59
The term of the license is important in assessing the arm’s-length
nature of the entire complex of
contractual relations, for as the
legal owner of a trademark transfers more of its rights for longer
periods, the licensee’s position
will move gradually from that of
a one-time user to that of a (beneficial) owner of the trademark.60
Within the framework of a group,
the license agreement frequently
fails to address the term of the license, making necessary the term
that unrelated parties would have
agreed on at the conclusion of the
agreement. To the licensee, an exclusive right to use the trademark
is obviously very important when
it seeks to achieve a reasonable
return on the investments that
it made in connection with the
license acquired, while on the
other hand, in practice, a license
is very often exclusive only if and
as long as the licensee can realize
certain sales of the brand-named
products, thus necessitating that
the contractual relationship between the owner of a trademark
and a related licensee will have
to show a balance between the
amount and the nature of the
licensee’s investments and the
requirements set on the success
of its efforts.61 When investigating the required balance between
the rights and obligations of the
Taxation of Corporate Transactions/February–March 2004
owner of the trademark and the
licensee, all aspects of the costs
of promotion and marketing must
be considered.62
The amount and form of the
royalty fee is also relevant to the
required balance between the
rights and obligations of the two
parties to a license agreement,
and there exists a wide range of
fee levels, depending on the (assumed) value of the trademark and
other conditions of the license. A
royalty can have many forms,
the most frequent of which is
the periodic royalty, based on
the sales of the brand-named
products (net invoice value). Additionally, there are once-only
or periodic payments of a fixed
sum. A licensee that acquires an
exclusive license for an indefinite
period for a fixed annual royalty
that can be terminated only by the
licensee is very close to the status
of fiscal or “beneficial” owner of
the trademark. In an intermediate
model, a fixed percentage of the
sales is stipulated for a similar,
“perpetual” license, and the parties can agree on such a fee if a
trademark that has become known
for a certain group of products is
further developed by the licensee,
through substantial investments,
for another group of products. The
fixed fee represents the value of
the trademark for the other product category at the time that the
license was initially granted.63
D. Cost-Sharing Arrangements
(CCAs) for MNEs
Within a multinational enterprise,
costs in relation to services that
are rendered within the group, or
in relation to products and services that the group developed
for the market, are increasingly
borne jointly by the relevant group
companies, with the anticipated
or relative benefits that each of the
companies can reasonably derive
serving as the key to allocating
the overall cost burden.64 Thus,
the progressive evolvement and
importance of cost-contribution
arrangements (CCAs) to manage
and quantify these relative or
anticipated benefits has evoked
detailed regulations thereon,
published in the United States
as well as the more recent OECD
Guidelines of 1996, 65 both of
which containing provisions on
the ownership of intangible property, as further developed based
on such CCAs.66
The assumed framework for
the CCA is an agreement upon
among business enterprises to
share the costs and risks of developing, producing or obtaining
assets, services or rights, and to
determine the nature and extent
of the interest of each participant in those assets, services or
rights.67 Further, “in a CCA, each
participant’s proportionate share
of the overall contributions to the
arrangement will be consistent
with the participant’s proportionate share of the overall expected
benefits to be received under the
arrangement bearing in mind that
transfer pricing is not an exact science.”68 The OECD Guidelines
further state:
[E]ach participant in a CCA
would be entitled to exploit its
interest in the CCA separately
as an effective owner thereof
and not as a licensee, and so
without paying a royalty or
other consideration to any
party for that interest.69
The view that the CCA participant must become at least
the “beneficial owner” of its interest and further would not be
required to pay any royalty is repeated several times in the OECD
Guidelines.70 This makes it evident
that the participant must become
at least the “beneficial owner” of
its interest, which at the start of
the arrangement is equal to “the
participant’s share of the overall
expected benefits” and cannot
be required to pay a royalty for
its use. The arm’s-length principle,
however, does not require that it
acquire the beneficial co-ownership of the brand itself. Merely
because the licensees enter into
a CCA (which may contribute to
a positive development of the
value of the brand for which the
license was granted) does not in
itself result in the licensees becoming the beneficial co-owners
for their territories of the brand.
It also is possible to develop an
entirely new brand under a CCA
based on assumptions and conditions that lead to co-ownership
of the developed brand for every
participant.
Unaffiliated parties will rarely,
if ever, agree that the licensor will
owe an amount for goodwill at the
end of the term of a license, and
that fact should be the result for
the tax treatment of licenses that
are granted in a group context. Toward the end of the license term,
however, its contribution to the
company’s “goodwill” has dissipated, and the licensure has lapsed,
which does not result in an obligation on the part of the trademark
owner/licensor to make payments
for the transfer of any “profit potential” or “goodwill.” The licensee
is not entitled to “goodwill” compensation at the end of the term
of the license based solely on that
circumstance, though it is possible
that the licensor/trademark owner
is capable of acquiring the ownership of marketing intangibles
33
Intellectual and Intangible Properties
that significantly contributed to
the goodwill of the licensee.71
Similarly, a licensor might owe
damages if the notice period
(determined at arm’s length) is
not observed, which must be considered by using the arm’s-length
principle as applied in the relevant
jurisdiction.
V. Forms of
Offshore Transfer
of Developed
Intangibles by
U.S. Persons—
Coordination
with Code
Nonrecognition
Provisions
A. Statutory and Regulatory
Background
To the extent that the intangible
owner is a U.S. person and the
U.S. intangible owner licenses or
transfers an intangible to another
affiliate or otherwise gives another
affiliate the use of the intangible,
the licensee/transferee generally
must compensate the U.S. intangible owner, depending upon the
nature of the transfer. U.S. transfer
pricing rules govern the amount of
compensation that is appropriate.
In this context, the term “transfer”
embodies all forms of a license,
sale or exchange of an intellectual
property right and can be effectuated in a number of ways:
A license for a lump sum and/
or a periodic royalty
A sale for lump sum and/or
contingent consideration
other than stock
A cross-license for the use of
transferee intangibles
A transfer for no consideration by way of a capital
contribution to a subsidiary
or a distribution to a parent
corporation
A transfer in exchange for
stock in the transferee
Illustration 5 Forms of Offshore Transfer of Developed Intangibles
by U.S. Persons
The Code Sec. 482 transfer pricing rules generally do not govern whether a transfer is taxable,
but instead govern the amount of consideration that must be received in a taxable transfer.
U.S.
PERSON
INTANGIBLES
FOREIGN
PERSON
CODE SEC. 482 PRINCIPLES
=
COMMENSURATE WITH
INCOME
Absent comparable uncontrolled transactions that demonstrate that the amount of consideration is arm's
length, Code Sec. 482 may affect the amount of consideration received or imputed in a transfer of intangibles
in two respects: The actual or imputed consideration received under the various types of transfers may be
required to be roughly equivalent as an economic matter.
Under the “commensurate-with-income” standard under Code Sec. 482, which was adopted by the Tax
Reform Act of 1986, the amount of consideration may have to be periodically adjusted to reflect the value of
the intangible as demonstrated, in hindsight, by the income actually derived from the intangible.
34
U.S. tax law technically does not
preclude any kind of transfer by
a U.S. person to a related foreign
person that could occur between
unrelated parties, but the U.S. tax
consequences of the various forms
of transfer may differ materially
in terms of whether the transferor
recognizes no income as a result
of the transfer of the intangible,
full gain on the transferred intangible at the time of transfer or
periodic royalty amounts over the
life of the intangible.72
The Code Sec. 482 transfer pricing rules generally do not govern
whether a transfer is taxable, but
instead govern the amount of consideration that must be received
in a taxable transfer. Absent comparable uncontrolled transactions
that demonstrate that the amount
of consideration is arm’s length,
Code Sec. 482 may affect the
amount of consideration received
or imputed in a transfer of intangibles in two respects: The actual
or imputed consideration received
under the various types of transfers may be required to be roughly
equivalent as an economic matter.
Under the “commensurate-withincome” standard under Code
Sec. 482, which was adopted
by the Tax Reform Act of 1986,
the amount of consideration may
have to be periodically adjusted to
reflect the value of the intangible
as demonstrated, in hindsight, by
the income actually derived from
the intangible.73
To the extent that intellectual
property rights are “bundled”
with services or tangible property
(e.g., hardware), the tax law does
not necessarily require the transaction to be bifurcated such that
the transfer of intellectual property
rights is separated from the transfer of hardware or the provision of
services.74 A transfer of property
Taxation of Corporate Transactions/February–March 2004
that includes the provision of services will be treated as a transfer
of property if any services are
merely ancillary and subsidiary
to the property transfer—i.e.,
the transaction, instead, must be
characterized in accordance with
the predominant aspect of the
transaction and further require
a reasonable allocation of consideration, if the services are not
merely ancillary and subsidiary
to the property transfer. There are
statutory solutions, or at least safe
harbors, for characterizing certain
transfers of intellectual property
(e.g., Code Sec. 1235 relating
to patents and Code Sec. 1253
relating to trademarks and tradenames), although transfers not
within the scope of those statutory
provisions must be characterized
under common law.
The IRS’s rulings under Code
Sec. 351 establish the IRS’s administrative position in distinguishing
sales from licenses of intellectual
property, and the IRS’s historical position is that a transaction
cannot qualify as a Code Sec.
351 tax-free exchange unless
the transfer would constitute a
sale or exchange or property
rather than a license absent the
application of a nonrecognition
provision. 75 Although there is
no generally applicable Code
section that determines when a
transfer of know-how is a sale
and not a license, the IRS has
adopted guidelines similar to the
rules of Code Sec. 1235 requiring a transfer of “all substantial
rights” by ruling that a transfer
of intellectual property is a sale
for federal income tax purposes
“where all substantial rights” to
the property have been transferred
to another. Finally, the ruling provides that an unqualified transfer
in perpetuity of the exclusive right
to use the formula, including the
right to use and sell the products
made from and representing the
formula, within all the territory of
the country, will be treated as the
transfer of all substantial rights in
the property of that country.76 IRS
has further defined the meaning of
“perpetuity” to mean the remaining statutory length of a patent in
the case of a transfer of a patent
or, in the case of a trade secret,
until it becomes general knowledge and is no longer subject to
substantial legal protection in the
jurisdiction.77
Consistent generally with IRS
rulings, under the case law, a
transfer of a patent generally is
treated as a sale if it is a grant of
an exclusive right to make, use
and sell patented articles for the
patent’s entire term in a country
or a limited area thereof, as well
as a grant of the right to prevent
unauthorized disclosure of the
know-how, although sale treatment has been denied for transfers
of exclusive licenses for less than
the full term of the patent. In addition, nonexclusive licensing
should not be treated as sales.
B. Code Sec. 1253
and Trademark Transfers
Code Sec. 1253 was intended to
clarify the treatment of transfers
of trademarks, trade names and
franchise rights that fall within the
terms of Code Sec. 1253. While
Code Sec. 1235 provides that
certain transfers (of patent rights)
are to be treated as exchanges,
Code Sec. 1253 provides that
certain transfers of trademarks,
trade names and franchise rights
will not be treated as sales or exchanges if the transferor retains
any significant power, right or
continuing interest in the subject
matter of the trademark or trade
name. Such retained significant
power or right that will result in
license treatment (and ordinary
income as opposed to long-term
capital gain) includes:
the right to disapprove of any
assignment of the trademark;
the right to terminate the arrangement at will;
the right to prescribe the standards of quality of products
used or sold or of services
furnished, and the equipment
and facilities used to promote
such products or services;
the right to require that the
transferee sell or advertise
only products or services of
the transferor;
the right to require that the
transferee purchase substantially all of his supplies and
equipment from the transferor;
and
the right to payments contingent on the productivity, use
or disposition of the matter
transferred, if such payments
constitute a substantial element under the transfer.78
Code Sec. 1031 generally applies to a transfer of intangible
property (as well as exchanges
of real property and tangible
personal property) that is held for
productive use in a trade or business or for investment in exchange
for property of “like kind” that is
also held for productive use in a
trade or business or for investment. The regulations provide
less guidance for the treatment of
exchanges of intangible property
than for tangible personal property and real property, stating that
intangible personal property is of
“like kind” to other intangible personal property depending on (1)
the nature or character of the rights
involved and (2) the nature of the
underlying property to which the
35
Intellectual and Intangible Properties
intangible relates.79 The regulations otherwise do not provide
any guidance relating to intangible property. Specifically, the
regulations do not provide classes
for intangible property because of
the variety of such property and
the lack of any generally available
classification system. Although
the IRS has issued a few private
rulings on like-kind exchanges
of certain intangibles, they give
little additional guidance as to the
scope of Code Sec. 1031, forcing
taxpayers to rely generally on the
common law definition of “likekind property.” The qualification
of a cross-license as a like-kind
exchange does not necessarily
mean that the transaction will
have no tax consequences, as
gain must be recognized in a
like-kind exchange to the extent
that the exchanged property rights
are not equal in value.80 If the
terms of the transfer by the U.S.
affiliate are such that the transfer
would constitute a license instead
of a sale (e.g., the cross-licenses
are nonexclusive licenses or the
cross-licenses can be terminated
at will by either party), then the
cross-license may not constitute
an “exchange” protected by Code
Sec. 1031.81
C. Nonrecognition Provisions for
Offshore Capital Contributions
and Stock Transfers
The transfer of intangibles to a
foreign corporation or partnership qualifies for nonrecognition
treatment subject to special rules
applicable under Code Sec. 367
if it constitutes a “transfer of property” under Code Sec. 351 (in the
case of a transfer to a foreign corporation) or under Code Sec. 721
(in the case of a transfer to a foreign partnership). If the transferor
that receives stock in a corpora-
36
tion does not qualify for tax-free
treatment under Code Sec. 351,
then the value of the stock received will be considered to be
an advance royalty to the extent
not attributable to other property
or services transferred or rendered
to the corporation, with the value
of stock received for services also
included in income at the time
received.
Alternately, if, in exchange for
a partnership interest, a person
contributes a right of use of an
intangible, or grants some other
right in an intangible that does
not constitute a “transfer of property” for purposes of Code Sec.
721, then the transfer potentially
should be considered an advance
royalty, equal to the value of the
partnership interest received. The
IRS’s position is that a transfer of
intangibles may not qualify as
a “transfer” for Code Sec. 351
purposes unless, absent the application of a nonrecognition
provision, the transfer would
constitute a sale or exchange,82
with the IRS position narrower
than the case law, which treats a
transfer as a sale even if the right
is limited to a specific geographic
area or subject to a field of use
restriction
The Code Sec. 367 rules preclude the tax-free transfer of
intangibles by a U.S. corporation to a foreign corporation
and apply only with respect to
“intangible property,” 83 which
for this purpose includes patents,
inventions, formulae, processes,
designs, patterns and know-how;
copyrights and literary, musical or
artistic compositions; trademarks,
trade names and brand names;
franchises, licenses and contracts;
methods, programs, systems,
procedures, campaigns, surveys,
studies, forecasts, estimates, cus-
tomer lists and technical data; and
similar items. However, the term
does not include an item that has
no substantial value independent
of an individual’s services.84 Code
Sec. 367(d) does not apply to the
transfer of foreign goodwill or
going-concern value, which is
the residual value of a business
conducted outside the United
States after subtracting the value
of all other tangible and intangible assets. Foreign goodwill or
going-concern value includes the
right to use a corporate name in a
foreign country.85 The regulations
under Code Sec. 367(d) contain
special rules regarding “operating intangibles,” a subcategory
of “intangible property,” which is
any intangible property of a type
not ordinarily licensed or otherwise transferred in transactions
between unrelated parties for
consideration contingent upon
the licensee’s or transferee’s use
of the property.86
Basically, when a transfer of
intangible property is subject to
Code Sec. 367(d), the transferor
is treated as having sold the property.87 Thus, the transferor makes
a fully taxable disposition, rather
than a tax-free capital contribution or exchange under Code Sec.
351.88 Generally, Code Sec. 367(d)
treats the transferor as receiving a
payment for the intangible property during each year of the useful
life of the property. The transferor
has deemed income only during
the useful life of the property. The
regulations place a 20-year cap on
the time period involved.
The useful life is the lesser of (1)
20 years or (2) the period during
which the property has value. If
the value of the property arises
from secrecy or legal protections,
the useful life ends when the
property is no longer secret or
Taxation of Corporate Transactions/February–March 2004
protected. If the useful life ends
unexpectedly, the transferor
should have no further income.
The regulations under Code Sec.
367(d) provide that Code Sec.
482 and its regulations govern
the amount of the income under
Code Sec. 367(d). If the foreign
corporate transferee pays royalties or periodic payments to an
unrelated person for the use of
the intangible property, those
payments reduce the amount of
income imputed to the transferor
under Code Sec. 367(d). Thus,
the transferor is deemed to have
received only the net amount.
VI. Transfer
Pricing—General
Application and
Regulatory History
of Code Sec. 482
A. Background
A multinational enterprise conducting international operations is
required to allocate its total profit
among the jurisdictions in which it
operates in a manner that permits
each country to tax an appropriate
portion of its total income, while
at the same time avoiding double
taxation of the same income by
more than one country, regardless
of whether the enterprise operates
worldwide through a single legal
entity or through a separate legal
entity in each country. For an MNE
operating through one or more
separate affiliates, domiciled in
each country, intercompany
transfer pricing involves setting
an appropriate level of compensation on transactions between
affiliates or other related parties,
also known as “intercompany
transactions.” Such intercompany
transactions might include setting a royalty rate on a license of
patents, trademarks or other intangibles by one affiliate to another,
or setting a sales price on goods
manufactured by one affiliate and
sold to another affiliate for further
manufacturing or distribution. The
royalty rate on a license between
affiliates, the sale price of goods
sold in a transaction between
affiliates, the amount paid for
services performed by one affiliate
for another and the compensation
paid in any other intercompany
transaction are all referred to as
transfer prices. Transfer pricing is
the most important area of audit
and litigation controversy in the
international tax arena because
they are easily identified and potentially involve large amounts of
revenue.89
It is an important fact that many
U.S. MNEs are more concerned
with increasing the amount of
foreign-source income available
for U.S. tax purposes than about
deferral potentials, as their effective U.S. tax rate is less than
their effective foreign tax rate,
and such a U.S. corporation that
has incurred foreign taxes (either
directly or through foreign subsidiaries) in general can claim a
foreign tax credit for those taxes,
but only against the U.S. tax imposed on foreign-source income.
Thus, the more foreign-source
income earned by such a U.S.
MNE, the larger the foreign tax
credit potentially available.90
B. The Intersection of Code
Secs. 367 and 482
The Code Sec. 367 rules were
materially modified in 1984 to
prevent the tax-free transfer of
even foreign intangible rights, and
under the current rules, if a U.S.
parent transfers intangible assets
to a foreign subsidiary, the U.S.
parent is deemed to sell the intangibles to the foreign subsidiary
for a sales price that is contingent
upon the use of the intangibles,
the effect of this provision requiring an annual imputation to the
U.S. parent of the amount that
would have to be paid as a royalty if the intangibles had been
licensed instead of transferred.
However, such amount imputed
under Code Sec. 367(d) (governing
outbound transfers) is treated as
U.S.-source income even though
imputed from a foreign corporation, whereas a royalty paid on
a license generally would be
treated as foreign-source income,
thus creating the need for foreign
source income treatment in order
to use available foreign tax credits
in a tax-efficient manner, with the
consequence being a tendency
that intangibles generally will be
licensed and not transferred to
foreign subsidiaries.
The outbound transfer rules
of Code Sec. 367 rules enforce
the Code’s requirement that the
income stream derived from U.S.developed intangibles is taxed to
the U.S. parent and accordingly
limits the ability of a U.S. MNE
group to transfer income-producing intangibles to foreign
subsidiaries in an effort to achieve
a deferral of U.S. tax. This resulting treatment of intangible income
imputed under Code Sec. 367 as
U.S.-source income generally
will make it desirable to license
intangibles to foreign subsidiaries
(instead of transferring the intangibles) since royalties paid on a
license will be treated generally as
foreign-source income. However,
regardless of whether or not intangibles are transferred or licensed,
transfer pricing issues will commonly arise as to the amount of
37
Intellectual and Intangible Properties
Illustration 6 The Intersection of Code Sec. 367 and Code Sec. 482
If a U.S. parent transfers intangible assets to a foreign subsidiary, the U.S. parent is deemed to sell the
intangibles to the foreign subsidiary for a sales price that is contingent upon the use of the intangibles, the
effect of this provision requiring an annual imputation to the U.S. parent of the amount that would have to
be paid as a royalty if the intangibles had been licensed instead of transferred.
IMPUTED INCOME
FOREIGN
INTANGIBLES
U.S.
PARENT
CORPORATION
SUBSIDIARY
TRANSFER IS DEEMED SALE
100% OWNED
Such amount imputed under Code Sec. 367(d) (governing outbound transfers) is treated as U.S.-source
income even though imputed from a foreign corporation, whereas a royalty paid on a license generally
would be treated as foreign-source income (thus the need for foreign source income treatment in order to
use available foreign tax credits in a tax-efficient manner), with the consequence being a tendency that
intangibles generally will be licensed and not transferred to foreign subsidiaries.
royalty or deemed imputed royalty
derived from intangibles licensed
or transferred to foreign subsidiaries, with the outbound rules
of Code Sec. 367 in tandem with
the arm’s-length rules of transfer
pricing under Code Sec. 482, assuring that a royalty equivalent
amount of intangible income
from U.S.-developed intangibles
is taxed to the U.S. developer of
the intangibles.
C. The Code Sec. 482 Rules
Armed with Code Sec. 482, the
IRS is able to allocate income,
deductions and other tax items
among related taxpayers to prevent the evasion of taxes while
simultaneously assuring that
the income of related taxpayers
is clearly reflected on their tax
returns. IRS regulations issued in
1968 contain the general principles for determining:
the amount of compensation
for services;
the royalty rate for a license of
intangible property;
the price for the sale of inventory or other tangible
property;
the amount of rent on leases
of tangible property; and
38
the rate of interest on related
party loans, all in the context
of related party inter-company
transactions.
Revised regulations issued in
1994 provide detailed guidance
on the selection of an appropriate
transfer pricing method, the process of measuring comparability
and the selection of methodologies based on particular facts and
circumstances of a related party
inter-company transaction.
The IRS initially applies the Code
Sec. 482 rules during the course of
an audit in examining the taxpayer’s income or deductions arising
out of intercompany transactions,
and if the IRS proposes an adjustment, the “burden of proof” shifts
to the taxpayer, who is required to
show that the proposed IRS adjustment is capricious, arbitrary or
unreasonable by using generally
one of two approaches:
The taxpayer represents that
the transfer prices selected
and used adequately comply
with the regulations, thus necessitating the rejection of the
IRS proposed adjustment.
The taxpayer simply offers
a compromise transfer price
to settle the controversy and
mitigate any penalties, which
IRS might statutorily assess.
Of course, if the transfer pricing
controversy is not settled between
the taxpayer and IRS, and assuming the taxpayer has exhausted its
IRS appellate remedies, the courts
become the venue for settlement,
with the courts exhibiting of late
a tendency to substitute their own
analysis and judgment for that of
both the IRS and the taxpayer.
By its terms, Code Sec. 482 applies only to transactions between
two or more organizations, trades
or businesses owned or controlled,
directly or indirectly, by the same
interests. Thus, Code Sec. 482 does
not apply to transactions between
parties that do not have common
ownership or control. For purposes
of Code Sec. 482, “controlled” refers to any kind of direct or indirect
control. The regulations provide
that “control” may result from the
actions of two or more taxpayers
acting in concert or with a common
goal. Formally separate ownership
arrangements will not avoid Code
Sec. 482 if control exists in reality. There is no bright-line test for
control under Code Sec. 482.
Code Sec. 482 applies regardless
of whether the organizations, trades
or businesses are organized in the
United States or are incorporated.
Code Sec. 482 commonly applies
to transactions between a U.S. corporation and its foreign subsidiary,
or between a foreign corporation
and its U.S. subsidiary.
Further, Code Sec. 482 also may
apply to transactions between two
foreign entities. The basic purpose
of Code Sec. 482 is to ensure that
taxpayers clearly reflect income
from controlled transactions and
do not avoid income from such
transactions. Code Sec. 482, at
least in theory, places a controlled
taxpayer on a tax parity with an
Taxation of Corporate Transactions/February–March 2004
uncontrolled taxpayer. The standard followed generally is that
of an uncontrolled taxpayer dealing at arm’s-length with another
uncontrolled taxpayer. In certain
areas, however, Code Sec. 482
may either impose or allow a different standard. Thus, for example,
the Code Sec. 482 regulations contain safe harbor rules for interest,
certain rents and certain payments
for services. Further, the last sentence of Code Sec. 482 allows the
IRS and the courts to judge payments for intangible property on
a look-back basis (i.e., taking into
account the income earned by the
intangible property after the year
of the transfer). In general, only the
IRS may invoke Code Sec. 482.
Thus, a taxpayer generally cannot
apply Code Sec. 482 at will or force
the IRS to do so. Once the IRS has
made an adjustment, however, a
taxpayer should have the right to the
appropriate correlative allocations.
Despite the general rule against invoking Code Sec. 482, a controlled
taxpayer may report its taxable
income based on arm’s-length
prices (on a return that is timely
filed, including extensions) even if
those prices differ from the prices
actually charged. The regulations
do not, however, permit a taxpayer
to decrease taxable income on an
untimely or amended return based
on adjustments with respect to controlled transactions. In an extreme
case, a domestic taxpayer may try to
shift income to a foreign entity that
did not really earn the income. The
IRS may then use Code Sec. 482 to
allocate 100 percent of the income
to the domestic taxpayer. More commonly, Code Sec. 482 results in a
partial allocation of income.
determining transfer prices for
intercompany transactions since
the IRS issued regulations under
a predecessor to Code Sec. 482
in 1935. Pursuant to this standard,
the appropriate transfer price of a
transaction between two related
parties is that price or range of
prices that would have been bargained for and agreed upon but
for the fact that the related parties
had not been related and accordingly deemed “uncontrolled,” and
is essentially a fair market value
standard that requires parties to
make hypothetical determinations
that are fact-dependent, judgmental and subjective in nature. Thus,
the room for controversy.
The transfer pricing regulations
of Code Sec. 482 reject as unsound
formulary methodologies, including those adopted by most states
within the United States, pursuant
to which state tax apportionment
methodologies typically allocate
income to activities within the
state on the basis generally of a
three-factor formula.91 The formulary approaches used in Advance
Pricing Agreements (APAs) in the
financial transactions area differ
from the formulary methodologies
used by the state or elsewhere in
the federal income tax law in that
the APA approaches attempt to
allocate income based on the
relative values of economic functions performed in earning income
and attempt to reach a reasonable
economic answer, while other formulary methodologies are purely
arbitrary, thus reaching a rational
and economic result only coincidentally.
D. The “Arm’s-Length” Principle
The Code Sec. 482 regulations
essentially require the use of comparable uncontrolled transactions
The “arm’s-length” standard
has been the benchmark in
E. Reliance on Comparable
Uncontrolled Transactions
in setting intercompany transfer
prices and additionally place
strong emphasis on comparability
of both the parties and the transactions in determining transfer
prices for related-party transactions,92 thus requiring the use of
the transfer pricing methodology
that produces the most reliable
measure of an arm’s-length price
in view of the data available and
its comparability to the transfers
at issue. The regulations 93 list
important factors in determining
a comparable royalty rate for licenses of intangibles, although in
practice, assuming a valid comparable transaction does not exist,
the methodology typically used is
in the form of a profit split or alternative analysis used to derive an
appropriate royalty rate that will
yield the desired result.
The final Code Sec. 482 regulations provide guidance with
respect to the use of three specific
methods for valuing intangibles.94
The comparable uncontrolled
transaction method searches for
licenses of “comparable” intangibles to determine an arm’s-length
royalty rate, while the comparable
profits method determines a royalty rate that provides the requisite
level of net profit to the licensee,
based on the profit level indicators
of comparable companies.
Additionally, the Code Sec.
482 regulations provide two
forms of profit split methods: the
comparable profit split which is
based on splits from comparable
arrangements involving comparable companies, although they
are difficult to find in the real
world; and the residual profit split
method, which allocates the combined income between the related
parties by first allocating income
to each party based on the arm’slength return each should receive
39
Intellectual and Intangible Properties
for performing specified functions,
with the remaining income allocated between the parties based
on some reasonable formula or
ratio based on the facts and circumstances, with this residual
amount presumed to be attributable to intangibles, this residual
split being similar to a type of
“excess earnings method.” Finally,
the regulations relating to sales of
tangible property set forth three
methods that basically require the
use of comparable uncontrolled
transactions, although alternative
methods are contemplated in the
absence of comparable transactions, including the comparable
uncontrolled price method, the
resale price method and the costplus method.95
F. Transfer Pricing Methodologies
1. The Comparable Uncontrolled
Price Method. The comparable
uncontrolled price method is
used when there are comparable
uncontrolled sales of the same
or similar products by either the
taxpayer or a competitor; for example, a foreign company in the
business of manufacturing that
sells inventory of its manufactured
product to both U.S. wholesale
distributors and to unrelated such
wholesale distributors located in
the United States.96
2. The Resale Price Method.
The resale price method is used
ascertain the proper markup for
a related-party distributor by attempting to locate and identify
resale profit margins of unrelated
distributors in the business of
distributing identical or similar
products and that in the distribution process perform similar
functions such as advertising,
product promotion and in-depth
marketing functions, but this
method cannot be used if such
40
related distributors so located
and identified own and employ
valuable marketing intangibles
(as comparable markups will be
difficult to isolate), perform additional pre-sale manufacturing
processes or own manufacturing
intangibles used by another affiliate in the manufacture of the
product. Such a scenario is found,
for example, wherein a domestic
(i.e., U.S.) parent purchases from
a foreign subsidiary products
manufactured with patents or
other intellectual or marketing
intangibles owned by such domestic parent, as illustrated by
the facts present in the landmark
transfer pricing case, Bausch and
Lomb.97 In this case, the resale
price method could not be used,
as no return for its manufacturing
intangibles was given the domestic parent. A similar scenario is
present in a situation involving
consumer products purchased by
a domestic subsidiary from a foreign parent if the product’s relative
profitability is a material consequence of extensive marketing
efforts by such domestic subsidiary, a significant presence in the
market as a result of the efforts of
the domestic subsidiary, or the
domestic subsidiary’s ownership
of valuable marketing intangibles
such as trademarks or tradenames.
The resale price method is similar
to the comparable profits method
in situations involving significant
adjustments to account for differences in “below-the-line” cost
structures, as it specifically ratifies using an operating margin as a
profit-level indicator for determining appropriate transfer prices.98
3. The Cost-Plus Method. The
“cost-plus” method is frequently
used to determine transfer prices
for manufacturers selling to related distributors, as illustrated by a
foreign subsidiary manufacturing
products with manufacturing intangibles owned by its domestic
parent, which in turn are sold
to other affiliates that market
the products. In this instance, a
markup or profit margin would
be calculated based on the foreign subsidiary’s manufacturing
costs in order to give the manufacturing subsidiary a profit that is
comparable to that earned by unrelated manufacturers performing
the same kinds of manufacturing
functions and assuming similar
risks.99
4. The Comparable Profits
Method. The comparable profits
method typically is used in transfer pricing situations when other
methodologies are either inapplicable or inaccurate due to a lack
of comparability and similarity in
data between compared entities
and the taxpayer entity, and functions by identifying comparable
companies performing similar
functions in order to determine
various profitability ratios such as
operating margins, return on assets,
et al., after making a provision for
adjustment incident to the various
comparables’ data in an effort to
resemble the controlled taxpayer,
typically by developing a range
of profit levels from the selected
and adjusted comparables and
then using these profit-level indicators to determine the amount of
profits for the controlled taxpayer,
allowing the controlled taxpayer
to interpolate or derive a transfer
price. This methodology is useful
in various situations, including
certain wholesale distributors (to
which a resale price method might
be applied) or manufacturer (to
which the cost-plus method might
be applied), both contingent upon
the availability of adequate data.
Additionally, this method can be
Taxation of Corporate Transactions/February–March 2004
useful as a form of “benchmarking” or as a “sanity check” to
compare for reasonableness in
testing transfer prices derived
in various situations, by both
taxpayer and IRS, in an effort to
resolve transfer pricing disputes
at the administrative level as an
attractive alternative to protracted
and expensive litigation.100
5. The Profit Splits Method. In
transfer pricing situations wherein
both controlled and related parties
own self-developed or purchased
intangibles, the profit splits
method is generally prevalent as
the methodology of choice and
is diverse enough to feature one
version which allows for profits to
be split based on how comparable
arrangements might split them and
another version which initially
allocates a return to identified
and normally routine functions
performed by each party, with
any remaining or residual split
based on appropriate allocation
factors specific to the facts and
circumstances in an attempt to
determine the relative value of
the intangibles owned by each
party.
VII. Quest for
Transfer Pricing
“Comparables”
A. Introduction
Transfer pricing law and analysis is
in the application of the essentially
straightforward concepts embodied in the facts and circumstances
of individual cases and is such in
both presentation and analysis. Although relatively few in number,
the seminal transfer pricing cases
reflect the evolution of Code Sec.
482 as well as the policy evolution
based on the planning patterns
evident in these cases since its
predecessor, Code Sec. 45. Code
Sec. 45 was enacted in the late
1920s to counter sophisticated
tax planning in shifting income
untaxed by U.S. hands to low
and no-tax jurisdictions, as selfevident in the 1936 landmark
transfer pricing case of Asiatic
Petroleum, 101 with prospective
principal cases involving major
MNEs, both domestic- and foreign-based, and tried in the U.S.
Tax Court, U.S. Court of Claims,
U.S. District Courts and the U.S.
Circuit Court of Appeals.102
To date, these principal cases
have not embodied or been tried
subject to the medicinal and
profound theoretical changes
enacted by the Tax Reform Act of
1986 (the “commensurate with
income requirement”), although
a generation of these soon will
germinate and multiply, as those
pricing issues involving related
parties are absent the arm’s-length
discipline of separate self-interest,
substituted by an apparent merger
of such interests.103 Although the
Code Sec. 482 regulations permit
some adjustment to uncontrolled
transactions that are not precisely
comparable in an effort to make
them comparable, the method
will be treated as the most direct and reliable measure of an
arm’s-length price only if the differences have no effect on price or
are minor and have a definite and
reasonably ascertainable effect on
price.104
Essentially, most transfer pricing
cases (over 350 cases decided to
date under Code Sec. 482) involve
a significant controversy about
whether comparable uncontrolled
transactions or comparable parties exist because of differences
between the intercompany transactions under examination and the
potential comparable transactions
or parties, regardless of whether
the methodology used compares
actual transactions 105 or gross
or net margins of comparable
parties,106 and further subject to
the inherent individual facts and
circumstances of the particular
controlled taxpayers and the
transactions at issue, lending to
transfer pricing the term labeled
upon valuation and appraisal professionals as an evolving body of
knowledge that is more art than
science.107
The concept of comparability
only can be learned theoretically,
without a working knowledge of
the principal transfer pricing cases
summarized briefly below, as it
generally is this concept that is
at the root of the controversy in
such litigation, and it is through
these cases in this evolving body
of knowledge that we have parameters as practitioners to guide
taxpayers through the hazardous
corridors to mitigate or avoid
costly transfer pricing penalties
as well as unpleasant administrative controversy or expensive
and protracted transfer pricing
litigation. There are several seminal and principle transfer pricing
cases in the period from inception
of Code Sec. 45 in the late 1920s,
as statutory predecessor to Code
Sec. 482, past the turn of the century (including the DHL decisions
as the century turned and the fate
of the U.S. Tax Court was dramatically overturned (by the U.S.
Court of Appeals) in 2002), and
the sampling below clarifies in a
practical manner the concept of
comparability, more subjective a
concept than most in the U.S. tax
law, and “more art than science,”
all as applied to the particular
facts and circumstances of these
leading cases.
41
Intellectual and Intangible Properties
The principle transfer pricing
cases tried under Code Sec. 482
and its predecessor (Code Sec. 45)
reflect the evolution of transfer
pricing. For the most part, these
cases involved large multinational
corporations (MNEs), reflecting a
broad range of global economy
sectors as well as the state of the
art in terms of international tax
planning methodologies from
approximately 1935 to date (i.e.,
from Asiatic Petroleum in 1935
to DHL in 2002). The case results
have provided an important base
for the evolution of regulatory
guidance in the transfer pricing
arena, although none of these
principal cases to date have addressed changes enacted to Code
Sec. 482 by the 1986 Tax Reform Act, adopting the so-called
“commensurate-with-income”
standard, which applies when an
intangible is transferred in a controlled transaction for a lump-sum
payment, wherein such a lumpsum payment made for the transfer
of the intangible in a controlled
transaction is treated as an advance on an income stream of an
arm’s-length transaction, which
must be commensurate with income over the useful life of the
intangible (or such period covered
by the agreement, if shorter). The
determination of the appropriate arm’s-length royalty stream
equivalent must take into consideration any projected sales by the
licensee and, using an appropriate discount rate, must include a
present value calculation of the
lump-sum amount.108
Although in these principle
cases, the purpose of the corporate structure producing the
pricing issue was an interesting
consideration, it was not the essence of the transfer pricing issue
at hand; rather, the pricing issue
42
was resolved on the basis of the
particular goods, service, intangible or capital transaction at
issue, and how such transaction
would have been structured by
unrelated parties dealing on an
arm’s-length basis. The concept
of risk is a common element in
each of these cases. Its presence
can be evaluated to determine
how unrelated parties dealing
at arm’s-length compensate the
risk-taker, as such economic risk
creates substance for tax purposes, and further, as evidenced
in many of these cases, the courts
are much more comfortable in
resolving pricing issues where
comparable bases are found—
such transactions are reflective
of the marketplace’s foundation.
In those cases where there are no
comparable uncontrolled party
transactions or transactions cannot be appropriately adjusted to
eliminate noncomparble factors,
the transfer pricing issues must
be resolved on the basis of the
facts and circumstances of the
case as well as the best evidence
available.
The results of these principal
cases lean heavily in favor of
taxpayer, with the government
winning few cases, some taxpayer
victories being “shutouts” and others compromised by splitting the
proposed and actual allocations,
indicating that the normal burden
of proof carried by the taxpayer
may not be as significant a matter
as first envisioned. It is noted that
although the sample is small, it is
representative; however, none of
these leading cases tried to date
have been so tried under the
“commensurate-with-income”
standard imposed by 1986 legislation, as the time it takes these
cases to arrive for litigation can
be quite protracted due to their
prior administrative compromise.
For those controversies unsettled,
the road to the courts is, indeed,
“long and winding.”
B. Comparability Viewed
Through a Summary of Case
Law Under Code Sec. 482
1. Ciba-Geigy Corp. Ciba-Geigy109
involved the appropriateness of a
10-percent royalty rate paid by a
U.S. subsidiary to a Swiss Parent
on an agricultural herbicide patent, with an offer by Dupont to
pay a royalty of 10 to 12.5 percent
held to be a valid comparable. The
IRS asserted multiple theories to
the effect that the parties had entered into a joint and cooperative
R&D agreement that should have
resulted in the U.S. subsidiary receiving a royalty-free license and
further that the royalty rate should
have been six percent instead of
10 percent. The Tax Court rejected
this theory and found that a fee
should have been paid for the research activities. Also interesting
in this case was the introduction
of evidence by the government,
which has subsequently been
cited prospectively by taxpayers,
that a licensor generally retains 25
percent of the profits from the exploitation of the intangible, while
the licensee generally earns 75
percent of the profits for its efforts
in exploiting the intangible.
2. U.S. Steel Corp. In U.S. Steel,110
the taxpayer was a U.S.-based,
vertically integrated producer of
steel products owning mines in
the United States and abroad.
Initially, the ore was transported
to the United States in chartered
vessels owned by independent
companies. Then the taxpayer
formed a Bahamian subsidiary for
the purpose of chartering ore carriers for transporting iron ore mined
aboard, with it accordingly entering
Taxation of Corporate Transactions/February–March 2004
into shipping agreements with third
parties, which assumed pre-existing
obligations of the U.S. company,
which also guaranteed such shipping agreements. The IRS argued
that U.S. Steel’s wholly owned
shipping company (“Navios”),
was charging too much for shipping ore from Venezuela to U.S.
ports. The Tax Court concluded
that a Code Sec. 482 reallocation
was appropriate in the circumstances, but the decision of the
Tax Court was reversed on appeal:
The Second Circuit found that no
such adjustment was appropriate,
accepting as comparable shipping
rates the rates charged by Navios
to unrelated steel producers, and
further rejecting the government’s
arguments that U.S. Steel could
have obtained lower rates from
unrelated shippers because of the
size of its shipments.
3. Perkin-Elmer Corp. In Perkin-Elmer,111 a U.S. corporation
(“Perkin-Elmer,” or “PE”) sold parts
and equipment to its Puerto Rican
subsidiary (“PEEC”), which manufactured finished products (highly
specialized optical equipment)
with intangibles licensed by PE
to PEEC. PEEC’s finished products
were sold back to PE. The court
examined the purchases and sales
of tangible property by PEEC and
the license of technology by the
taxpayer to PEEC, focusing on
transactions between taxpayer
and unrelated parties as well as
between unrelated parties (not including the taxpayer) as potential
comparables. The court applied
the resale price method to the
sales by PEEC to PE, using resale
margins derived by PE from the
sale of products purchased from
unrelated parties and treating
the arrangement as an exclusive
distributorship arrangement, but
the court specifically rejected the
argument that an exclusive distributorship results in high price items
necessarily having higher margins
and further, basing its adjustment
on actual prices paid on PE’s
resales (not invoiced amounts),
making no adjustments requested by the government, due to the
absence of data quantifying the
adjustments requested.112 Finally,
the court increased the royalty
rate on products manufactured by
PEEC (with the exception of one
product line—lamps) based on
an earlier licensing arrangement
by the taxpayer to a third party.
Throughout Perkin-Elmer, the
court required an exacting degree
of specificity and certainty before
it would accept any comparable
or adjustment proposed by either
side, it being less concerned with
the methodology employed than
with the comparability of the third
party data to the related party
transactions.
4. Westreco Inc. In Westreco,113
the court rejected the IRS’s use of
an unadjusted and unanalyzed
group of companies that were
selected solely on the basis of
their Standard Industry Classification Codes in determining
a cost-plus markup for contract
research. This case is notable not
only for the controversy between
taxpayer and IRS counsel as to
procedural matters, but also for
eliminating the use of industry
averages in determining transfer
prices, with the final Code Sec.
482 regulations clarifying that
such use of industry averages
will not meet comparability requirements.114
5. Nestle Holdings. Nestle
Holdings115 held that the value
of a transferred intangible cannot
be determined solely by applying
a “relief from royalties” methodology, under which the value of
an intangible is determined with
reference to the present value of
the royalties the transferee would
be requested to pay to use the
trademarks. The Appeals Court
found that this methodology undervalues trademarks in the case
of an outright transfer, because the
transferee in a trademark sale has
the right to determine when and
where to use a mark, including
the determination of which product lines will bear the mark, and
is not subject to temporal or other
limitations on a licensee’s use of
the trademark.116
6. DHL Corp. In the DHL
case,117 the IRS sought to allocate,
under the authority of Code Sec.
482, additional capital gain income to DHL for the 1992 sale of
the DHL trademark to DHLI/MNV
for $20 million, arguing at trial
that the trademark had a $300
million value at the time of the
sale, while DHL contended on
essentially two grounds that an
allocation of additional capital
gain income was inappropriate.
It first contended that $20 million was an arm’s-length price,
arguing that DHL owned only
the rights to the U.S. trademark
(as opposed to ownership of the
trademark worldwide, which
would be worth more). DHL
further contended that the $50
million value of the trademark
that was considered during the
negotiations established a ceiling
on the trademark’s value. DHL
explained that the $20 million
value was established based on
a determination that DHLI/MNV’s
other assets (both tangible and intangible) were far more valuable
than the trademark.
In conclusion of this aspect
of the DHL saga, the Tax Court
held that the worldwide DHL
trademark had a value of $100
43
Intellectual and Intangible Properties
million at the time of its sale,
specifically rejecting DHL’s
argument that $80 million of
this gain should be allocated to
DHLI because DHLI was the developer of the trademark within
the meaning of the developer-assister regulations, and held that
the worldwide DHL trademark
had a value of $100 million at
the time of its sale. The court also
rejected DHL’s argument that
$80 million of this gain should
be allocated to DHLI because
DHLI was the developer of the
trademark within the meaning
of the developer-assister regulations. Accordingly, an additional
$80 million in capital gain income was imputed to DHL. 118
The Ninth Circuit reversed the
Tax Court on the royalty, trademark purchase price and penalty
issues, based on its focus on the
1968 regulations (the tax years
at issue in DHL were covered by
the 1968 regulations) and found
that DHLI developed the nonU.S. trademarks because it had
spent in excess of $340 million
in the preceding 10-year period
promoting in various ways the
mark outside the United States,
while DHL had promoted the
mark only in the United States.
As the economic owner of the
non-U.S. rights to the DHL
trademark, the Ninth Circuit
found that DHLI owed no royalty for the use, exploitation or
purchase of a mark that it had
developed.
This conclusion largely eliminated the IRS adjustments against
DHL. The Ninth Circuit then
correspondingly eliminated the
accuracy-related penalty imposed by the IRS, finding that the
Bain “comfort” letter established
that DHL had acted reasonably.
Further, the result in DHL was
44
supported by the Ninth’s Circuit finding that DHLI was still
conducting business in an immature or undeveloped market
for the years 1982–1992. Hence,
it appears that the Ninth Circuit
assumed that all expenses were
developmental and not routine. In
this instance, it is clear that some
expenses are routine in maintaining the status of the trademark in
the market while others may be
earmarked for further development and enhancement of the
trademark. It also appears that
the Tax Court required DHL to
establish that DHLI expenditures
above this threshold actually were
incurred relevant to the development of the non-U.S. trademark
rights, with the Ninth Circuit not
requiring the level of specificity as
that of the Tax Court.119
7. Compaq Computer Corp.
In Compaq Computer Corp.,120
Compaq purchased components
for the personal computers that it
manufactured from its Singapore
subsidiary (Compaq Asia), and
also manufactured those same
components in the United States
as well as made additional purchases from a number of unrelated
manufacturers. Compaq faced the
burden of establishing that the IRS
notice of deficiency, in which the
IRS applied a comparable profits
method, was arbitrary, capricious
or unreasonable and that the prices
that Compaq paid to Compaq Asia
were arm’s length. After concluding that the IRS’s transfer pricing
results were unreasonable, primarily because of large discrepancies
between the notice of deficiency
and the government’s position in
the litigation, the court addressed
the appropriateness of the prices
charged by Compaq Asia, basing
its decision on the regulations in
effect prior to January 1, 1994,
focusing only on the application
of the comparable uncontrolled
price (CUP) method.
Compaq offered purchasing
data from 14 unrelated manufacturers as its comparables, which
the court accepted because,
while not identical to the purchases from Compaq Asia, they
were sufficiently similar to allow
reasonable price adjustments
to reflect any differences. The
court considered adjustments
for minor physical differences in
the products and differences in
production time, design services
provided by Compaq Asia but not
by the unrelated manufacturers,
higher freight and duty costs for
the purchases from Compaq Asia,
compensation due to Compaq
Asia for setup and cancellation
charges, and inventory risk borne
by Compaq Asia because of raw
material purchases based on nonbinding forecasts.
The court rejected the government’s contention that volume
discounts should apply to Compaq Asia’s sales, noting that
the evidence indicated that the
prices charged by the unrelated
manufacturers were not related to
volume, but that rather Compaq
was in such a dominant market
position that it was able to receive
the best prices from all manufacturers, regardless of volume. The
court also rejected the government’s contention that the high
profit margins earned by Compaq
Asia were indicative of an inflated
purchase price paid by Compaq.
The court noted that the relative
cost structures of the related and
unrelated manufacturers were irrelevant to the CUP analysis and
that the evidence established that
the prices charged by Compaq
Asia were consistent with arm’slength market prices.
Taxation of Corporate Transactions/February–March 2004
VIII. Cost-Sharing
Agreements (CCAs)
and Buy-In/BuyOut of Developed
Intangibles
A. Background
Generally, the final regulations
contain a basic buy-in requirement that mandates controlled
participants to make appropriate
allocations for transferred tangible
and intangible property to reflect
arm’s-length consideration121 and
provide further that any changes
in the controlled participant’s
interest in the arrangement may
necessitate further adjustments,
including terminating or exiting
the arrangement (i.e., the buyout), while buy-in payments
may be netted against any other
payments owed to the participant122 While these rules may at
first blush appear flexible, they
do not provide a safe harbor for
valuing intangibles apart from
the traditional rules set forth in
the regulations for intangibles,
thus making unresolved the issues
under the buy-in rule for workin-progress or noncommercial
intangibles or preexisting intangibles that are being upgraded or
replaced. Further, the rules and
available guidelines for “buy-in”
payments apply equally to “buyout” payments within the context
of developed intangibles.
B. Difficulties in Buy-In and
Buy-Out Valuations
If a controlled participant to a
cost-sharing agreement makes
intangible assets such as pre-existing intangibles, or unfinished
“work-in-process” R&D for intangible projects available to the
other participants for purposes of
the cost-sharing agreement, an
arm’s-length “buy-in” payment
must be made to the owner for
the use of the intangible assets.123
Certain items not qualifying as
identifiable intangible assets can
be considered value or competitive factors and influences,124
although the existence of many
of these characteristics may indicate the existence of valuable
nonroutine intangible assets or
comprise a part of an overall marketing intangible. Determining the
amount of the buy-in (or buy-out)
payment involves difficult fact and
circumstance coupled with valuation issues that can directly affect
the buy-in or buy-out mechanism
contained in cost-sharing agreements. Such valuation issues
arise when the buy-in payment
is made for pre-existing intangible assets, although identifying
the appropriate valuation model
components, business synergies
and useful lives of these apparent
pre-existing intangible assets can
be problematic.
These intangibles can include
the following:
Marketing-related intangible assets (e.g., trademarks,
tradenames, brand names and
logos)
Technology-related intangible
assets (e.g., process patents,
patent applications, technical
documentation, such as laboratory notebooks, technical
know-how and work-in-process R&D)
Artistic-related intangible assets (e.g., literary works and
copyrights, musical compositions, maps and engravings)
Data processing-related assets
(e.g., proprietary computer
software, software copyrights,
automated databases and in-
tegrated circuit masks and
masters)
Engineering-related intangible
assets (e.g., industrial design,
product patents, trade secrets,
engineering drawings and
schematics, blue prints and
proprietary documentation)
Customer-related intangible
assets (e.g., customer lists,
customer contacts, customer
relationships and open purchase orders)
Contract-related intangible
assets (e.g., favorable supplier
contracts, license agreements,
franchise agreements and
noncompete agreements)
Human capital-related intangible assets (e.g., a trained
and assembled workforce,
employment agreements and
union contracts)
Location-related intangible assets (e.g., leasehold interests,
mineral exploitation rights,
easement, air rights and water rights)
Goodwill-related intangible
assets (e.g., institutional goodwill, professional practice
goodwill, personal goodwill
of a professional, celebrity
goodwill and general business
going-concern value)125
Complexity increases when
the intangible asset involves
unfinished “work-in-process”
R&D, although several primary
valuation models are available
to resolve these calculations,
including the discounted cash
flow (DCF), relative value and
option models. These models can
be further categorized based on
assumptions about the business
growth into stable-growth, twostage and three-stage models, with
the measurement of earnings and
cash flows adjusted to match the
special characteristics of the com-
45
Intellectual and Intangible Properties
pany or transaction being valued.
For the use of multiples, the price
can be expressed in various terms,
and the multiples themselves can
be calculated by using comparable
companies in the same business,
from cross-sectional regressions
that use the broader universe or
from fundamental analysis.126
Under the DCF models, the
value of a business generally is
the future expected cash flow
discounted at a rate that reflects
the riskiness of the cash flow. Under the relative valuation model
(sometimes called the “accounting approach”), the importance of
earnings of the business entity is
stressed. The third approach uses
an option-pricing model, which
estimates the value of assets that
have option-like characteristics.
Generally, options are derivative
securities that derive their value
from underlying assets. These
traditional valuation models
(e.g., discounting projected cash
flows, earnings multiples and
option-pricing) may be highly
speculative in the context of
the buy-in payment for work-inprocess intangible assets simply
because there may be little or no
reliable cash flows or historical
sales or profits on which to base
projections and calculations, and
further, these quantitative models
do not accurately measure the
value of “synergy” which refers
to the potential additional value
gained from combining two businesses or companies, either from
operational or financial sources.
Stated another way, a whole
is greater than the sum of the
parts.
Under cost-sharing agreements,
the issues are generally limited
to:
which costs are shared under
the agreement;
46
how costs are to be shared
among the participants in the
agreement;
which values are attributable
to intangibles developed prior
to use in the agreement (the
“buy-in”); and finally,
what are the administrative
requirements for the IRS to
respect the agreement.127
Assuming that a controlled participant to a cost-sharing agreement
makes intangible property available
to the other participants for purposes of the agreement, an arm’s-length
“buy-in payment” must be made to
the owner for the use of the intangible, which is generally in the form
of either pre-existing intangibles or
unfinished “work-in-process” R&D
for intangible projects. As discussed
in this section, the IRS has recently
issued FSAs that highlight the
complex issues that may arise in
the determination of the necessity
of, and further, the amount to be
paid, as well as the form of such
payment, since such a determination involves difficult factual and
valuation issues. Although the IRS
has complained about perceived
abuses of the buy-in process and
the potential undervaluing of existing intangibles used in cost-sharing
agreements, such abuses seem to
arise primarily in the context of
CCAs established in low-tax or
no-tax jurisdictions or in situations
wherein such cost contributions to
the CCA are inconsistent with the
benefits and results of the arrangement. It is quite normal that such
valuation problems arise when
the buy-in is made for pre-existing intangibles, as even the task
of identifying the components,
synergies and useful lives of these
pre-existing intangibles can be
challenging.128
Several possible methods have
been suggested for valuing a
work-in-process buy-in, including the traditional comparable
uncontrolled transactions (CUT)
method and the comparable profits method (CPM), although for
the former method, comparable
uncontrolled transactions are difficult at best to find, whereas the
latter approach can produce wide
fluctuations in rate-of-return data
and imprecise comparables due
to the sheer residual nature of the
approach. These fluctuations may
cause substantial year-to-year variances in the valuation process. As
suggested earlier, a DCF analysis
may be employed, although its results can be speculative at best in
certain circumstances and should
only be used as a “sanity check”
on the best method selected, as it
otherwise is prone to the distortion
of results.
C. Parameters for
Buy-in Payments
Parameters for establishing the
value of buy-in for the projected
value of the work-in-process
component of an R&D project
might for companies with a
history of R&D projects be determined by using the company’s
historic expected rate of returns
for corporate investments, its
anticipated cost of capital or
some accounting method of
depreciation allowance for inprocess R&D that is written off
for book purposes, as the floor
and the ceiling may be the present value of the expected income
stream to be derived from the intangible asset being developed,
with such ceiling derived from
the income flows of comparable
intangibles, business projections
or even the fair market value (or
in some instances, market capitalization) of the entire business
unit appropriately discounted or
Taxation of Corporate Transactions/February–March 2004
adjusted for market characteristics, assets not contributed and
business unit synergies. In situations where the business unit is
either publicly traded or the
subject of a recent acquisition,
the business unit value might be
somewhat determinable and subject to various adjustments, such
as reduction for any incremental
value brought to the acquired
unit by the purchaser.
Although several methods have
been suggested for valuing a
work-in-process buy-in payment
including the traditional comparable uncontrolled transaction, the
comparable profits method and a
profit-split approach, each of these
more traditional methodologies
have shortcomings in this area and
can cause wide variations in value.
In certain circumstances, the DCF
method may be used despite its
speculative nature, but one of the
limitations of the DCF method is
its failure to consider assets that do
not produce cash flows currently
and are not expected to produce
cash flows in the near future, but
are valuable nevertheless because
of their potential to produce value
for the company,129 with the valuator prospectively and historically
forewarned that, absent favorable
alternatives, prior to the stock market swoon of the past couple of
years, the IRS was currently prone
to using this or a similar market
capitalization approach in the absence of an alternative or because
it yielded a favorable tax result.
A market capitalization approach generally uses the price of
a company’s stock as the starting
place for valuation of the company’s intangible assets subject to the
amount of the buy-in payment.130
The market capitalization residual
method (MCRM) (a common form
of market capitalization method
used by IRS in proposed adjustments as recently as the last stock
boom) involves first the estimation
(i.e., preferably by a limited appraisal valuation calculation for
each and all of a company’s intangible assets, albeit it a complex
and subjective process, requiring
the precise identification of
each intangible asset, and then
separately valuing each of them,
again requiring more, more and
more analytical and complex
valuations, as well as the sheer
number of valuations, thus involving substantially more cost
in lieu of a more passive and less
expensive process of simply estimating the value of the intangible
asset comprising the cost-sharing
agreement.131
Although the market capitalization method logically appears at
first glance to represent the “true
value” of a company using all
available information and based
on the functioning of efficient
markets, it can be argued that
such a methodology does not
adequately address the assumption that a company’s total value
always equals the separate sum
total of its market capitalization
(as by and large, even for small
and middle-sized publicly traded
companies, the sum total of its
authorized, issued and outstanding shares multiplied by such
shares’ publicly traded market
price equals the value of such
company (for both tangible and
intangible assets) on a controlling
(minority) marketable basis, thus
not recognizing the true value of
the company nor any synergistic
values.
Care should be exercised in
timing and application of this
method, as the price paid by a
prospective acquiror may include
values for such synergies, changes
in business plan or other matters
not reflective of the underlying asset value or stock price that is the
subject of the “buy-in” payment.
Further, stock prices may fluctuate
over time due to many events not
related to underlying asset value,
such as in applying the price-toearnings ratio approach, another
market capitalization derivative
which assumes the company will
be worth some multiple of its
future earnings in the continuing
period—obvious, but difficult to
approximate in reality and thus in
practice as well.
The market-to-book ratio approach assumes the company
will be worth some multiple of
its book value, often assumed
to be or interpolated from the
current multiple or the multiple
of comparable publicly traded
companies, creating a form of
mandatory circular reasoning in
order to prove the efficacy of such
methodology.
D. IRS Regulatory Response
and Guidance with Respect to
Buy-In Payments
1. Field Service Advice (FSA)
200023014. Through FSA
200023014, the IRS admits application of and further even
suggests that the market capitalization method might be deemed
appropriate for the valuation
of a buy-in, assuming certain
facts and circumstances.132 This
FSA also noted that a profit-split
analysis might be useful when
two or more parties contribute
nonroutine intangibles to the costsharing arrangement, although its
effective application is questioned
by recent commentators.133 FSA
200023014 espouses that the
valuation of the buy-in payment,
especially work-in-process, generates complex issues as well as
47
Intellectual and Intangible Properties
the possibility of administrative
controversy or litigation with the
IRS. FSA 200223014 secondly addresses the form of payment for
the buy-in, allowing buy-in payments in lump sums, installments
or via royalty payments to parties
to a cost-sharing agreement.
Nothing in the regulations or
elsewhere supports the proposed
field service advice position that
buy-in royalties must continue for
the life of the intangible asset, as
experience suggests that many
taxpayers dealing at arm’s length
purposefully place a time limit on
royalties that is generally shorter
than the life of the intangible,
though the official IRS position
is that on audit, it may propose a
Code Sec. 482 reallocation in an
attempt to increase the length of
a royalty payment stream.
2. FSA 20001018. Another
controversial field service advice
deals with buy-ins, illustrating
again how important proper
form is for effective cost-sharing
agreements with foreign subsidiaries, as well as costs paid by such
foreign subsidiaries for updating
its technology as well as those respectively for special technology
used in manufacturing operations.
The primary question in the instance of this FSA was whether or
not such a foreign subsidiary is required to make a buy-in payment
to its domestic parent for certain
technology, as well as current
and prospective payment to the
extent of continuing or additional
research in the technology area,
surmising that such foreign subsidiary is required to contribute to the
acquisition of certain technology
(the buy-in) and to any work done
to improve or update that or other
specified technology (additional
cost-sharing payments). Thus, in
some instances, it is advisable to
48
incorporate additional technologies into an existing cost-sharing
agreement, while in others, it may
be more beneficial to have certain
technologies outside the costsharing agreement and therefore
subject to the normal arm’s-length
transfer pricing rules. Further, the
FSA asserts that the subsidiary
must make buy-in payments
over five years, including three
years still open under the statute
of limitations, with such “statute
position” allowing the IRS generous opportunities to examine
and subsequently become alert
to any missing or omitted buy-in
transaction.
While methods and approaches
to the valuation of buy-in payments are generally similar to
buy-out payments, some differences do exist. The first noticeable
such difference is the evaporation
of termination or winding down of
a cost-sharing arrangement, in that
the synergies that may have existed throughout the combination
of joint efforts of the parties (or the
comparable benchmarks) may not
exist or may be severely impaired,
generally resulting in the probable
and significant diminution of the
company’s fair market value as
a going concern, pre-valuation.
Additionally, the value of any
“work-in-process” R&D may be
significantly discounted without
the prospective availability of the
joint efforts of the parties, including the significant value accorded
an “assemblage of work force,”
evaporated upon dissolution.
Facts control the valuation result
and any corresponding adjustments, premiums or discount
factors of the valuation.
Finally, cost-sharing payments
that are received by one affiliate
from another are generally treated
as deductible research and devel-
opment expenses to such payor
affiliate, and characterizations
of these payments under foreign
law do not impact this generally
desired result, even if the local
laws of the foreign jurisdiction in
question do not recognize costsharing arrangements.134
3. Proposed Regulations Under Code Sec. 482. Proposed
Regulations (REG-146893-02 and
REG-115037-00, Sept. 5, 2003)
under Code Sec. 482 abandon
the developer-assister rules that,
in the absence of a bona fide
cost-sharing arrangement, designate a single entity within the
affiliated group as the developer
(or initial owner for tax purposes)
of intangible property and entitled
to compensation from the use or
exploitation of that intangible
property, without regard to legal
ownership. The current Regulations, which were promulgated
in 1994, create a distinction between intangibles that exist and
have value as a result of legal
protection (“legally protected
intangible property”), such as a
trademark, and other intangibles.
These Regulations apply the developer-assister rules to intangible
property that is not legally protected intangible property. Actual
legal ownership of legally protected intangible property determines
the right to compensation from
affiliated entities that use or exploit such intangible property.
Proposed Reg. §1.482-4(f)(3)(i)
would instead provide that the
entity that is the legal owner of
intangible property pursuant to
the intellectual property law of
the relevant jurisdiction should
be the sole owner of intangible
property and presumably should
receive the income that the group
generates from the use or exploitation of such intangible property.
Taxation of Corporate Transactions/February–March 2004
If the intellectual property law of
the relevant jurisdiction does not
identify an owner for the intangible property, the entity within the
affiliated group that has control of
the intangible property would be
considered the sole owner of the
intangible property. The Proposed
Regulations would make an exception if applying the intellectual
property law of the relevant jurisdiction would produce ownership
that would be inconsistent with
the economic substance of the underlying transactions. They suggest
that Reg. §1.482-1(d)(3)(ii)(B)(2),
which allows the imputation of a
contractual agreement consistent
with the economic substance of
the transaction, would then be applicable. (See Henry J. Birnkrant,
Transfer Pricing for Services Is
Broadly Affected by New Prop.
Regs., Mostly Not for the Better,
J. TAX’N, Jan. 2004.)
IX. U.S. Charitable
Contributions
of Intellectual
and Intangible
Properties
A. Code Sec.170 Applicability,
in General
Code Sec. 170 allows an income
tax deduction for any charitable
contribution made during the
tax year. “Charitable contributions” for this purpose mean gifts
of money or other property to
domestic nonprofit educational,
charitable and religious organizations exempt from tax under
Code Sec. 501(c)(3), and to federal, state and local governmental
organizations serving a public
purpose. An individual donor’s
charitable contribution deduc-
tion is limited to a percentage of
his or her taxable income for the
year (computed without regard to
net operating losses carried back
to the year). The percentage limitations are generally 50 percent for
donations to entities classified as
public charities and private operating foundations and 30 percent
for donations to entities classified
as private foundations. Charitable
contributions in excess of these
limitations may be carried forward
for five years and deducted in the
first available year for that period,
subject to the applicable percentage limitation in the particular year.
A corporation may take charitable
contribution deductions of up to
10 percent of its taxable income
for the year (computed without
regard to net operating loss carrybacks and certain other items).
Charitable contributions in excess
of the 10-percent limitation may
be carried forward for five years
and deducted in the earliest available year in that period, subject
to the 10-percent limitation each
year.135
Code Sec. 170(f)(3) expressly
disallows a deduction for a contribution of a partial interest in
property. A “partial interest” is any
interest in property that consists of
less than the donor’s entire interest
in the property. A contribution of
only the right to use property is
considered a donation of a partial
interest in the property. A deduction of an “undivided portion of
the [donor’s] entire interest in
the property” is not treated as a
partial interest, however, and thus
is eligible for a deduction under
Code Sec. 170. For this purpose,
the regulations state that an “undivided portion of an owner’s entire
interest in property must consist of
a fraction or percentage of each
and every substantial interest or
right owned by the donor in such
property and must extend over the
entire term of the donor’s interest
in such property.”
The concept of a tax benefit
conditioned on giving away no
less than all of one’s rights in
property has company in the tax
world when patents are involved.
Code Sec. 1235 provides that a
inventor or certain assignees of an
inventor may be able to treat gain
on the sale of intellectual property
as long-term capital gain (rather
than ordinary income), regardless
of the holding period, but only if
the sale involves “all substantial
rights to” the intangible property
or “an undivided interest therein
which includes a part of all of
such rights.” Under these rules,
“all substantial rights to a patent”
means that the rights sold may
not be:
limited geographically within
the country of issuance,
limited in duration to a period
less than the remaining term
of the patent,
limited to fields of use within
trades or industries, or
less than all the inventions
covered by the patent.
Restrictions placed on donated
property do not prevent a charitable deduction for the value of
the gift, but they do affect the
amount of the donation.
B. Rev. Rul. 2003-28136
Rev. Rul. 2003-28 confirms that
a donation of substantially all
rights in intellectual property
(i.e., a patent) generates a charitable contribution deduction, but
a donation of only a subset of the
rights in such property, or a donation of intellectual property rights
that is subject to a material contingency, does not. Second, the
most interesting question regard-
49
Intellectual and Intangible Properties
ing charitable donations of such
property is how to value them.
Though the gift must be properly
structured, the challenge comes
in arriving at a valuation that
will survive scrutiny.137 Rev. Rul.
2003-28 presents three scenarios
in which a patent holder makes a
contribution to an entity exempt
from income tax under Code Sec.
501(c)(3). In the first, the patent
holder contributes a license to
use the patent, but retains the
right to license the patent to others. Not surprisingly, the IRS ruled
that a donation of a nonexclusive
license amounts to a donation of
a “partial” interest in the patent,
since Code Sec. 170(f)(3) denies a
charitable contribution deduction
for donations of partial interests in
property, unless the partial interest constitutes the taxpayer’s entire
interest in the property. The statute
is clear on this point, but the ruling
does not give attention to the specific nature of a patent and what
constitutes a partial interest in a
patent. The ruling does not refer
to Code Sec. 1235 for guidance
as to what a “partial interest” in a
patent is, but could have looked
to the regulations promulgated
under Code Sec. 1235, which
make it clear that retaining the
right to exploit a patent is a substantial right.
C. Valuation Issues
In the case of contributions of
intellectual property such as patents and patent rights, the amount
deductible is the fair market value
of the property at the time of the
contribution. In this context, fair
market value means:
... the price at which the
property would change hands
between a willing buyer and
a willing seller, neither being
50
under any compulsion to buy
or sell and both having reasonable knowledge of relevant
facts, with the amount of the
allowable deduction for the
contribution of a patent will
be the fair market value of the
patent interest transferred, and
fair market value is always a
question of fact.
Thus, the taxpayer claiming a
charitable deduction for contributed property has the burden of
proving that the amount of the
claimed deduction reflects the
fair market value of the donated
property. 138 Three methods are
commonly used to value patents
and patent rights: the income
method, the market method and
the cost method. The income
method attempts to value a patent based on the present value of
the “stream of future economic
benefits that one can enjoy by
owning it.” The market approach
relies on an analysis of the pricing
at which assets comparable to the
property being valued were sold at
or around the valuation date. This
method is common and has been
respected by the courts because
it can reflect clearly what a buyer
in the market would be willing to
pay for comparable property in
an arm’s-length transaction. The
cost or adjusted net asset method
analyzes value by “aggregating all
of the costs necessary to re-create”
the property rights being valued.
This method has been seen as
useful in valuing charitable contributions of unusual property.
When applied to the valuation
of intellectual property including
patent rights, the cost approach
may fail to consider important
factors such as profits from commercializing, investment risk and
earnings growth potential.
Conclusion
The United States asserts such
the jurisdiction of residence over
“persons” of the United States,
including citizens and residents,
domestically organized corporations and partnerships and
domestic trusts and estates, and
accordingly taxes such persons
on their worldwide income. Under Code Sec. 865, the source of
income from a transfer of intellectual property is determined
by the characterization of the
transaction as a sale for fixed
payments, a sale for contingent
payments, a sale of depreciable
personal property, a nonsale license or personal compensation.
The purpose of the source rules is
to assert the United States’ source
jurisdiction to tax income that has
sufficient and reasonable nexus
with the United States, using two
convenient tests that determine
the source of income derivation
of the country in which the capital
or property is used.
The general rule regarding the
characterization of a sale for
source rule purposes is that a sale,
following patent sale principles
by analogy, requires the transfer
of all substantial and valuable
rights in the intellectual property
for the legal life of the intellectual
property. The Code also imposes a
30-percent gross withholding tax,
imposed at the source on the gain
within contingent payment sales
of intellectual property and paid
to nonresident alien individuals
and foreign corporations, unless
it is effectively connected with the
conduct of a U.S. trade or business,
in which event the Code imposes
special rules on certain transfers of
intellectual property by/between
related persons, which are subject
to special rules that limit the abil-
Taxation of Corporate Transactions/February–March 2004
ity of U.S. persons to shift income
to foreign entities that are otherwise exempt from U.S. taxation in
an effort to avoid current taxation.
Capital contributions of intellectual property by U.S. persons to
foreign corporations in otherwise
nonrecognition transactions are
taxable as “contingent payment
sales” creating “deemed annual
royalties” over the useful life of
the contributed property, coupled
with an abrasive super royalty
regime that is applicable to contributions of “intangible property,”
measured by the yet-tested “commensurate with income” standard
attributable to the intangible and
effectively recharacterizing related
party transactions on an arm’slength basis, creating complex
difficulties regarding the valuation
of intellectual property.
The outbound transfer rules
of Code Sec. 367 rules enforce
the Code’s requirement that the
income stream derived from U.S.
developed intangibles is taxed to
the U.S. parent and limits the ability to transfer income-producing
intangibles to foreign subsidiaries
in an effort to achieve a deferral of
U.S. tax classified as U.S.-source
income, making it generally desirable to license intangibles to
foreign subsidiaries (instead of
transferring the intangibles). Royalties paid on a license generally
will be treated as foreign-source
income, with such royalty rate
on a license between affiliates,
the sale price of goods sold in
a transaction between affiliates,
the amount paid for services performed by one affiliate for another
and the compensation paid in any
other intercompany transaction all
being referred to as transfer prices,
the issue of which is the most important area of audit and litigation
controversy in the international
tax arena because they are easily
identified and potentially involve
large amounts of revenue.
Within a multinational enterprise, costs in relation to services
that are rendered within the group
or in relation to products and services that the group developed for
the market are increasingly borne
jointly by the relevant group companies, with the anticipated or
relative benefits that each of the
companies can reasonably derive
serving as the key to allocating the
overall cost burden, resulting in
the progressive evolvement and
importance of CCAs, to manage
and quantify these relative or anticipated benefits. Determining the
amount of the buy-in (or buy-out)
payment involves difficult fact and
circumstance coupled with valuation issues that can directly affect
the buy-in or buy-out mechanism
contained in cost-sharing agreements, with the reward being that
such cost-sharing payments that
are received by one affiliate from
another are generally treated as
deductible R&D expenses to such
payor affiliate, with the added
benefit of such characterizations
of these payments under foreign
law not impacting this generally
desired result.
The OECD Guidelines classify
commercial intangibles as “trade
intangibles” and “marketing intangibles,” and describe the concept
of a “trademark” specific product.
As with all intellectual property
rights, the object of ownership
(the trademark) is a creation of
the law of the state concerned,
which creates an exclusivity for
the owner of such commercial
intangibles via the registration of
the trademark, granting it the use
and exploitation of the idea or
concept, to the exclusion of others, giving full legitimacy to the
fiscal ownership of the trademark
residing with its legal owner, unless all of the essential rights to
a trademark in a jurisdiction
are transferred to the licensee,
in which case the arm’s-length
principle requires the existence
of an assumed balance between
the rights and obligations of the
two parties on the conclusion of
the license agreement.
To the extent that the intangible
owner is a U.S. person and the
U.S. intangible owner licenses
or transfers an intangible to another affiliate or otherwise gives
another affiliate the use of the intangible, the licensee/transferee
generally must compensate the
U.S. intangible owner. In this
instance, U.S. transfer pricing
rules govern the amount of
compensation that is appropriate, and absent comparable
uncontrolled transactions that
demonstrate that the amount of
consideration is arm’s length,
Code Sec. 482 may affect the
amount of consideration received
or imputed in a transfer of intangibles. In a period in which the
prices that companies can charge
for their goods and services are
permanently under pressure, it
appears that only companies
that have valuable intangibles
can actually offer unique products and services and thus escape
the continuing process of price
erosion. Differentiating an intellectual property transaction for
federal income tax purposes as
between a license versus a sale
turns on the extent to which the
transferor maintains proprietary
rights in the underlying property
after the transfer is completed,
with the greater the transferor’s
ongoing dominion and control
over the property, the less likely
the classification as a sale.
51
Intellectual and Intangible Properties
ENDNOTES
1
2
3
4
5
6
7
8
9
52
John J. Cross, III, Taxation of Intellectual
Property in Intellectual Transactions, 8 VA.
TAX REV. 553 (Winter 1989).
See Code Sec. 901(a). U.S. persons are granted
a foreign tax credit against their U.S. tax liability for foreign taxes paid. This credit is subject
to a limit under Code Sec. 904, computed by
multiplying United States tax liability (before
the foreign tax credit) by a ratio of net foreign
source (emphasis added) taxable income over
worldwide taxable income. Therefore, the effect is that domestic multinational corporations, which typically have excess unusable
foreign tax credits (because of the corporate
rate reductions under U.S. law since the passage of the 1986 Tax Reform Act (P.L. 99-514)),
want to increase foreign source income to raise
the Code Sec. 904 limit to enable them to use
greater foreign tax credits.
Code Sec. 871(a)(1)(D).
See Reg §1.871-11(c) (1974) (the principles
of Code Sec. 1253, which govern capital
gain sale or exchange treatment for transfers
of trademarks, trade names and franchises,
are inapplicable to determine whether a
transfer is a sale or exchange for purposes
of Code Sec. 871).
See Code Sec. 865(a). The general rule of Code
Sec. 865 for source income from the sale of
property is subject to exceptions for inventory
property under Code Sec. 865(b), depreciable
personal property under Code Sec. 865(c),
certain intangible property under Code Sec.
865(d) and property sold through fixed places
of business under Code Sec. 865(e).
An individual’s “tax home” is “... his regular
or principal (if more than one regular) place
of business, or, (if none), his regular place
of abode in a real and substantial sense,”
or, in any event, in the United States, if the
individual’s abode is in the United States. Reg.
§1.911-2(b) (1985). Second, no U.S. citizen or
resident alien shall be treated as a nonresident
for purposes of a personal property sale unless
such person actually pays a foreign tax equal
to at least 10 percent of the tax gain.
See Reg. §1.871-11(c).
See Code Sec. 1235(a). The term “all substantial rights to a patent” means “all rights
(whether or not then held by the grantor)
which are of value at the time the rights to
the patent (or an undivided interest therein)
are transferred.” Reg. §1.1235-2(b).
The current benchmark for a Code Sec. 1235
sale is articulated by D. Kueneman, CA-9, 802 USTC ¶9616, 628 F2d 1196, 1200, which
held that a geographically limited transfer of
a patent is precluded from Code Sec. 1235
treatment. See also C.W. Gilson, 48 TCM
922, Dec. 41,437(M), TC Memo. 1984-447
(a professional inventor’s transfer of design
patents qualifies for Code Sec. 1235 treatment
because all substantial rights were transferred
for a flat fee). In J.H. Pickren, CA-5, 67-2 USTC
¶9477, 378 F2d 595, 600, the court determined that an exclusive license of a trade secret for a 25-year period failed to constitute
10
11
12
13
14
15
16
17
18
19
20
a sale, since a trade secret has an indefinite
life. The court stated, ”... [s]ecret formulas and
trade names are sufficiently akin to patents to
warrant the application, by analogy, of the tax
law that has been developed relating to the
transfer of patent rights, in tax cases involving
transfers of secret formulas and trade names.”
In Rev. Rul. 55-17, 1955-1 CB 388, the IRS
ruled that unpatentable “know-how” can be
transferred for consideration and is sufficiently
like a secret process such that payments can
be treated as royalty income. See, e.g., J.O.
Tomerlin Trust, 87 TC 876, 891-892, Dec.
43,466 (1986), wherein the court held that the
transfer of all substantial rights in a trademark
for contingent payments constituted a sale for
purposes of the personal holding company
rules, notwithstanding failure of the transaction to qualify as a sale eligible for capital
gains treatment under Code Sec. 1253.
See Code Secs. 871(a), 881(a) and Code
Secs. 1441(a), 1442(a).
See Reg. §1.1441-2(a)(3) (“[i]ncome derived
from the sale in the United States of property,
whether real or personal, is not fixed or determinable annual or periodical income”).
Code Secs. 871(b) and 882(a).
Reg. §1.871-11(d).
Reg. §1.167(a)(3).
For copyrights, equal to (1) in the case of an
author, the life of the author, plus 50 years;
(2) in the case of work for hire, the shorter of
75 years from publication or 100 years from
creation; or (3) in the case of a purchaser,
35 years from the date of purchase.
Reg. §1.1441-2(a)(3).
Code Secs. 871(a)(1)(D), 881(a)(4), and Code
Secs. 871(b) and 882.
A fixed place of business is any fixed facility
through which a foreign person engages in a
trade or business, including factories, stores
and sales outlets. See Reg. §1.864-7(b)(1).
See Reg. §1.864-6(b)(2)(i). An office is a material factor in the production of intellectual
property royalty or sales income if the office
actively participates in soliciting, negotiating or performing other activities required
to arrange the property transfer or performs
significant services incident to the transfer.
Mandating, for example, the attribution of a
partnership’s fixed place of business to each
of its partners, and having as its purpose an
overriding source rule designed to prevent
foreign persons from using the United States
as a tax haven by conducting business
through fixed places of business in the United
States and manipulating the inventory place
of title source rules to generate foreign source
income exempt from U.S. tax. The practical
effect of the application of this Section is to
create United States “source effectively connected business income” taxed on a net basis,
since income attributable to a domestic fixed
place of business invariably will constitute
effectively connected U.S. trade or business
income under Code Sec. 864(c).
Including intellectial property.
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
I.e., related persons.
Code Sec. 367(d)(2)(C).
Code Secs. 861(a)(4) and 862(a)(4).
Code Sec. 367(d)(2)(A), as added by the Tax
Reform Act of 1986, and thus, requires that
the amount of the deemed annual royalty in
covered transactions be “commensurate with
the income attributable to the intangible.”
Code Sec. 936(h)(3)(B).
Code Sec. 367(d)(1).
See Reg. §1.482-2(d).
Including a Code Sec. 936 (possession)
corporation.
Code Sec. 936(h) contains rules that apply to
Code Sec. 936 possession corporations (i.e.,
Puerto Rico, et al.) not covered herein.
Code Sec. 1253 is generally applicable to
the transfer of a franchise, trademark or trade
name, whereas a franchise for this purpose
means an agreement that grants the right to
distribute, sell or provide goods, services or
facilities within a specified area.
Code Sec. 1253(a).
Code Sec. 1253(b)(2)(A).
Code Sec. 1253(c).
J.O. Tomerlin Trust, supra note 9; where the
taxpayer granted an exclusive, perpetual license to use a trademark to produce, sell
and distribute certain automotive products,
the court stated that Code Sec. 1253 did not
create a new standard for defining sales and
licenses and that pre-Code Sec. 1253 case
law governs the issue. Finding the transfer
to be a sale and not a license, it reasoned
that the transferee’s rights were unlimited
in territory and were perpetual, and the
taxpayer was bound to transfer legal title to
the trademark after the transferee made a
specified amount of payments.
Dairy Queen “fast food” franchises in each
instance, as follows: Dairy Queen of Oklahoma, Inc., CA-10, 58-1 USTC ¶9155, 250
F2d 503; G.R. Gowdeny, Est., CA-4, 62-2
USTC ¶9603, 307 F2d 816; V.H. Moberg,
CA-5, 62-2 USTC ¶9662, 305 F2d 800;
V.H. Moberg, CA-9, 62-2 USTC ¶9824, 310
F2d 782; F.C. Wernentin, CA-8, 66-1 USTC
¶9140, 354 F2d 757.
Like the Tenth and Fourth Circuits, it found
the quality control and other rights retained
by the transferor to be protective and not
proprietary in nature. As to the contingent
consideration, the court remanded and
subsequently held that such payments were
separate and apart from the sales price of
the franchise rights and thus were royalties,
representing a retained interest in the earnings of the franchise.
The court disagreed with the Fifth Circuit,
however, about the other set of contracts,
emphasizing that these did not specify restrictions on quality control, the transferee’s
product line or bookkeeping methods. The
transferors under these contracts reserved
the right to set such restrictions over time,
and the court found such ongoing authority
inconsistent with a sale.
Taxation of Corporate Transactions/February–March 2004
ENDNOTES
38
39
40
41
42
43
44
45
46
47
48
The court not only reviewed the contract
provisions but also emphasized the transferor’s substantive involvement in the business after the transaction, which included
training, technical/business involvement on
a weekly basis, control over subfranchisees
and other activities.
Stokely USA, Inc., 100 TC 439, Dec.
49,052.
Nabisco Brands, Inc., 69 TCM 2230,
Dec. 50,543(M), TC Memo. 1995-127. In
Nabisco Brands, the transferee paid $25
million to the transferor at closing for the
Life Savers trademarks and agreed to make
additional, annual payments for 10 years.
The parties projected that the total annual
payments for the 10-year period would be
approximately $28.2 million. Actual annual
payments for the period totaled approximately $28.7 million. The ultimate amount
of each annual payment depended on the
transferee’s sale of Life Saver products, but
the parties did agree to a fixed, minimum
amount for each payment. For the tax years
at issue, approximately 25 percent of each
annual payment was contingent and further
represented approximately 25 percent of the
total consideration, fixed and contingent,
paid by the transferee over the period. The
court ruled that these contingent payments
were substantial within the meaning of Code
Sec. 1253(b)(2) and consequently that the
transferor’s retained rights were significant.
Resorts International, Inc., CA-5, 75-1 USTC
¶9405, 511 F2d 107.
Consolidated Foods Corp., CA-7, 78-1 USTC
¶9180, 569 F2d 436.
See, for example, Rev. Rul. 87-63, 1987-2
CB 210; LTR 8823006 (Dec. 23, 1987), LTR
8828027 (Apr. 14, 1988), LTR 8842041 (July
26, 1988), LTR 9032010 (May 10, 1990) and
LTR 9852033 (Sept. 29, 1998).
Accordingly, Congress prescribed in the
statute that the transferor’s retention of any
significant right prevents the transfer from
being the sale of a capital asset. Accordingly, the transferor’s retention of just one
right, significant within the meaning of
Code Sec. 1253(a) or Code Sec. 1253(b)(2),
should serve to classify the arrangement as
a license, not a sale.
Contingent consideration for this purpose
means any amount contingent on the use or
productivity of the transferred property if it is
part of a series of payments payable at least
annually throughout the term of the agreement and substantially equal in amount or
payable on a fixed formula.
Code Sec. 1253(d)(1), (2) and Code Sec.
197(a), (d)(1)(F).
Multinational enterprises.
Section 6.3 of the OECD Guidelines address
“commercial intangibles. The latter category
includes (Section 6.4) “trademarks and trade
names that aid in the commercial exploitation of a product or service” and “customer
lists, distribution channels, and unique
49
50
51
52
53
54
55
56
57
58
59
60
61
names, symbols, or pictures that have an
important promotional value for the product concerned.” This category could be
extended to include “intangibles” such as
trademark licenses, studies and concepts
for campaigns. With regard to know-how
and trade secrets, the OECD Guidelines
(Section 6.5) state that these can be either
trade intangibles or marketing intangibles.
See generally Fred C. de Hosson, Multinationals and the Development, Ownership,
and Licensing of Trademarks, Trade Names:
Part 1, J. INT’L TAX’N, Sept. 2000.
In Germany, the law did not provide for a
free transfer until 1992. U.S. law stipulates
that a trademark must be transferred together
with all of its “associated goodwill,” but does
not require that the operating business be
transferred as well.
In the United States, for example, infringement actions can be instituted only by the
legal owner, which, in a U.S. context, often
may imply that it is desirable that a local
group company register the trademark.
Reg. §1.482-4(f)(3)(ii)(A), T.D. 8552 (July 1,
1994).
See generally Hosson, supra note 49.
Reg. §1.482-4(f)(3)(ii)(A).
See Mentz and Carlisle, The Tax Ownership of Intangibles Under the Arm’s Length
Principle, 97 TNI 208-16, and Planning the
Location of Future Income and Deductions,
INTERTAX, 1997/3, at 85.
OECD Guidelines, Chapter VI (Special
Considerations for Intangible Property),
Section D “Marketing activities undertaken
by enterprises not owning trademarks or
trade names”).
Just because unrelated parties would make
a division of functions and risks different
than related group companies is in itself
not a ground to ignore such a division
and can only give rise to an investigation
into whether adjustments of the prices are
required to reflect that deviating division. In
this regard, see also the example in OECD
Guidelines, Section 1.41.
Levey et al., US Distribution Companies Can
Present Difficult Transfer Pricing Issues, INTERTAX, 1999/3, at 89.
See Reichert, Observational Equivalence
and the Cheese Example Under the Final
Section 482 Transfer Pricing Regulations, TAX
MANAGEMENT TRANSFER PRICING REPORT (BNA),
Sept. 3, 1997, at 275.
An (exclusive) license that can be terminated
only by the licensee must be considered
extremely long term, if not “perpetual,”
and under the circumstances, it will make
the licensee the (beneficial) owner of the
trademark in its territory.
A balancing act will be required in an
exclusive license—where it is easier for a
licensee to recover his investments—since
in an unrelated situation, the licensor will
often insist on a clause that will allow him to
terminate the license or remove its exclusive
62
63
64
65
66
67
68
69
character, if the licensee is not sufficiently
successful. With respect to promotion and
marketing costs, a balance must exist for
both parties between rights and obligations.
The licensee’s obligations may be spelled
out in great detail and require significant
spending by him (which is then balanced,
for instance, by his low royalty payments),
but it may also be, as happens in real life
between unrelated parties, that the licensee
is completely free to incur these costs or
not (which no doubt will be balanced by
other terms, e.g., nonexclusive license, high
royalty).
It is therefore not only relevant whether
the licensee bears exceptional costs for the
development of the trademark in the territory assigned to it; other relevant aspects of
the contractual relations that exist between
unrelated parties must be considered as
well—for example, whether the owner
of the trademark also incurs costs for the
development of the global brand name. It
is also significant whether the licensee has
a contractual obligation to bear promotion
and advertising costs up to a certain amount.
Unrelated parties also frequently grant full
discretionary power to the licensee with
regard to the amount of its expenditure on
promotion of the licensed trademark.
In such situations, the licensee often cannot
be regarded as the beneficial owner of the
trademark, as the licensor continues to have
an obvious financial interest in the development of the trademark by the licensee. To
protect the positioning of its trademark, it
will usually not allow the licensee to apply
the trademark entirely at its own discretion
or to transfer the license to a third party at
its own discretion. On the other hand, it is
obvious that the licensee will be prepared
to invest substantial amounts in the development of the trademark for an entirely new
group of products only if it acquires considerable long-term rights, which may not grant
it the beneficial ownership of the trademark,
but definitely place it in a stronger position
than that of a mere user.
See Hosson, supra note 49.
OECD Guidelines, Chapter VIII, Cost Contribution Arrangements (June 1996).
See Hosson, supra note 49.
Section 8.7 of the OECD Guidelines points
out that while CCAs for R&D of intangible
property are perhaps most common, CCAs
need not be limited to this activity. They
could exist for any joint funding or sharing
of costs and risks, for developing or acquiring property, or for obtaining services. The
example specifically named is “the development of advertising campaigns common
to the participants’ markets.” It is not stated
anywhere that the less common forms of
CCAs are subject to conditions other than
those discussed.
Supra note 65.
OECD Guidelines, Chapter VIII, Cost Con-
53
Intellectual and Intangible Properties
ENDNOTES
70
71
72
73
74
75
76
77
78
79
80
81
54
tribution Arrangements, Section 8.3.
OECD Guidelines, Chapter VIII, Cost Contribution Arrangements (June 1996), see
Sections 8.4 and 8.6.
This pertains in particular to the acquisition
of the customers (market share) that the licensee recruited independently.
See generally JOEL D. KUNTZ and ROBERT J.
PERONI, U.S. INTERNATIONAL TAXATION (2002);
and KEVIN DOLAN, U.S. TAXATION OF INTERNATIONAL M ERGERS , A CQUISITIONS AND JOINT
VENTURES (2002).
Id.
See Rev. Rul. 64-56, 1964-1 CB (Part 1)
133.
See Rev. Rul. 69-156, 1969-1 CB 101.
Id., supra note 74.
See Rev. Rul. 71-564, 1971-2 CB 179.
See LTR 9852033 (Sept. 29, 1998) which
held that the transfer of foreign rights to a
trademark constitutes all substantial rights
for purposes of Code Sec. 1253, even though
the U.S. transferor retains all U.S. rights with
respect to the trademark.
Thus, the exchange of a copyright on a novel
for a copyright on a different novel is a likekind exchange because the intangibles are
the same and the underlying properties are
the same. But an exchange of a copyright
on a novel for a copyright on a song is not
a like-kind exchange, because the underlying properties are different. The regulations
provide that goodwill or going concern
value of a business is not of “like kind” to
the goodwill or going concern of another
business.
In addition, the IRS has held that Code Sec.
482 may be applied in a Code Sec. 1031
like-kind exchange between related parties
to impute additional compensation if the
value of the intangible right received by the
U.S. transferor is not equivalent to the value
of the transferred intangible. Furthermore,
under the commensurate-with-income
standard of Code Sec. 482, additional
compensation can be imputed to a U.S.
transferor in a related party cross-license in
subsequent years following the exchange
(a “periodic adjustment”) if it becomes
apparent that the transferred intangible is
ultimately more valuable than the intangible
right received.
In circumstances in which Code Sec. 1031
does not apply, taxpayers have generally
been assuming that, as a tax accounting
matter, it would be inappropriate for the IRS
to assert that the U.S. affiliate has an advance
royalty upon entering into the cross-license
equal to the value of the license right received in exchange. Instead, the worst result
assumed is that, if the IRS were to impute
royalty income to a U.S. affiliate under a
cross-license, the IRS would be required to
grant concurrent deductions for imputed
royalties paid to the foreign affiliate equal
in amount to the imputed royalty income
(on the assumption that the cross-license
82
83
84
85
86
87
88
89
90
91
is value-for-value), thereby producing a
wash.
See Rev. Rul. 64-56, 1964-1 CB 133.
For these purposes, within the meaning of
Code Sec. 936(h)(3)(B).
The regulations define “intangible property”
to mean “knowledge, rights, documents,
and any other intangible item within the
meaning of Code Sec. 936(h)(3)(B) that
constitutes property for purposes of Code
Sec. 332, 351, 354, 355, 356, or 361, as applicable.” Code Sec. 367(d) applies without
regard to whether the property will be used
for manufacturing or marketing. Further,
Code Sec. 367(d) applies without regard to
where a foreign corporation intends to use
the intangible property, whether inside or
outside the United States.
Code Sec. 367(d) also does not apply with
respect to a copyright, letter, memorandum
or literary, musical or artistic composition
held by the taxpayer who personally created
the property. Further, Code Sec. 367(d) does
not apply with respect to a letter, memorandum or similar item held by a taxpayer
for whom the letter or memorandum was
produced. Finally, Code Sec. 367(d) does
not apply with respect to a copyright, letter,
memorandum or literary, musical or artistic
composition held by any taxpayer with a
basis determined (for purposes of gain on
a sale) in whole or part by reference to the
basis of the item in the hands of either the
taxpayer who produced the item or the taxpayer for whom the item was produced.
Operating intangibles for these purposes
may include long-term purchase or supply
contracts, surveys, studies and customer
lists.
See Code Sec. 367(d)(2)(A).
The regulations under Code Sec. 367(d),
however, generally avoid the sale concept
and speak instead of a transfer for contingent
payments. Moreover, the regulations do not
appear to allow the basis of the intangible
property to be recovered as in a sale.
See KUNTZ & PERONI and DOLAN, supra note
72.
Further, it is notable that increasing or reducing the amount of the royalty paid by the
foreign subsidiary will not affect the amount
of foreign-source income ultimately derived
by the U.S. parent, since the royalty payable
by the foreign subsidiary is foreign-source
income to the U.S. parent.
Such three-factor state apportionment methodology typically takes into account payroll,
property and sales within the state relative to
the total of payroll, property and sales of the
corporation or, in some instances, of a group
of affiliated corporations that compose a
unitary business. The obvious arbitrariness
of state tax allocation formulae has caused
the U.S. federal government traditionally to
reject formulary income allocation methods
and has caused the international tax community to adopt the arm’s-length standard
as the norm of international tax policy.
Increasingly, Congress has indicated dissatisfaction with the results reached by the
IRS under the arm’s-length standard, and
some members have called for the use of
formulary apportionment in some cases. The
arm’s-length standard has been criticized for
both theoretical and practical reasons. From
a theoretical perspective, it does not take
into account the synergies arguably inherent
in a multinational enterprise.
92
The final Code Sec. 482 regulations deleted
a provision in earlier temporary regulations
authorizing the IRS to create formulary safe
harbors for small taxpayers. Temporary
Reg. §1.482-2T(f)(1). Unless otherwise
indicated, all references to the regulations
under Code Sec. 482 are to the final Code
Sec. 482 regulations (also referred to as the
1994 regulations), which are contained in
Reg. §§1.482-0 through 1.482-8.
93
1968 Code Sec. 482 regulations.
94
Reg. §1.482-1.
95
Id.
96
Id.
97
Bausch and Lomb, Inc., 92 TC 525, Dec.
45,547 (1989), aff’d, CA-2, 91-1 USTC
¶50,244, 933 F2d 1084.
98
Id. The resale price method can apply only
to the simplest distributing affiliate which
does no manufacturing, sells products that
are not marketing driven (where marketing
intangibles are not important) and does not
own manufacturing intangibles used by the
manufacturing affiliate.
99
Note: A cost-plus method that uses full absorption costing as the base for measuring
the applicable “profit-to-cost” ratio is, in
actuality, a form of comparable profi ts
methodology which is discussed in the
next section. The cost-plus method is not
useful in transfer pricing situations involving a foreign manufacturing subsidiary that
owns significant manufacturing intangibles
used in the manufacture of the products,
as it would not give the foreign subsidiary
sufficient profit to reflect the value of
its manufacturing intangibles and their
contribution to the overall profit from the
product.
Using the court’s analysis in Bausch and
Lomb, Inc., the cost-plus method may not be
applied by identifying comparable markups
of contract manufacturers, i.e., a manufacturing affiliate that owns no manufacturing
intangibles, performs no marketing functions
and assumes little or no market risks. Most
importantly, neither the resale price method
nor the cost-plus method can be used if both
parties possess significant manufacturing or
marketing intangibles.
100
As in the case of the resale price method and
cost-plus methods, it generally should not be
used to determine the profit level of a related
party that owns significant intangibles.
101
Asiatic Petroleum Co. (Del.), Ltd., CA-2,
35-2 USTC ¶9547, 79 F2d 234.
Taxation of Corporate Transactions/February–March 2004
ENDNOTES
102
See generally, LOWELL, BURGER and BRIGER,
U.S. INTERNATIONAL TRANSFER PRICING (2d ed.
2002).
103
Id.
104
Reg. §1.482-3(b)(2)(ii).
105
I.e., sales prices or royalty rates under the
comparable uncontrolled price or transaction method.
106
I.e., under the resale price or comparable
profits method, respectively.
107
Personal opinion as a valuation professional,
also, and the term” art over science,” a
phrase used by my firm in its marketing of
our business and tax valuation practice.
108
Arup K. Bose, The Effectiveness of Using
Cost Sharing Arrangements as a Mechanism
to Avoid Intercompany Transfer Pricing Issues with respect to Intellectual Property,
21 VA. TAX REV. 553 (Spring 2002).
109
Ciba-Geigy Corp., 85 TC 172, Dec. 42,271
(1985).
110
U.S. Steel Corp., CA-2, 80-1 USTC ¶9307,
617 F2d 942, rev’g, TC Memo. 1977-140.
111
Perkin-Elmer Corp., 66 TCM 634, Dec.
49,268(M), TC Memo. 1993-414.
112
This case is significant for its analysis of
groupings of products and not the aggregate
of all intercompany sales in applying the
resale price method. Thus, there was a different margin for each grouping of products.
The court made no adjustment to the prices
charged by PE to PEEC on parts purchased
by PEEC from PE, owing to the absence of
sufficient information in the record to enable
the court to make such an adjustment.
113
Westreco Inc., 64 TCM 849, Dec. 48,527(M),
TC Memo. 1992-561.
114
See Reg. §1.482-4(f)(4).
115
Nestle Holdings, Inc., CA-2, 98-2 USTC
¶50,606, 152 F3d 83.
116
Because the “relief from royalty” methodology has been widely used, this case may result in an increase in the value of trademark
intangibles in outright transfers subject to
Code Sec. 482.
117
DHL Corp., 76 TCM 1122, Dec. 53,015(M),
TC Memo. 1998-461, aff’d in part, rev’d in
part, CA-9, 2002-1 USTC ¶50,354, 285 F3d
1210.
118
The concept of the “developer” rule is that
the party that incurred the costs and risks of
developing the intangible should not be required to pay a royalty to use that intangible.
If the costs and risks of development are
proven and the identity of the bearer of such
costs and risks is established, it is unnecessary to show the existence of a cost-sharing
agreement, as the regulations provide that
this rule applies “in the absence of a bona
fide cost sharing arrangement.”
119
Levey, Shapiro, Cunningham, Lemein and
Garofalo, DHL: Ninth Circuit Sheds Very
Little Light on Bright-Line Test, J. INT’L TAX’N,
Oct. 2002.
120
Compaq Computer Corp., 78 TCM 20, Dec.
53,443(M), TC Memo. 1999-220.
121
See generally Reg. §§1.482-1 and 1.482-4
through 1.482-6.
122
Reg. §1.482-7(g)(1).
123
Id.
124
These include market share, high profitability, lack of regulation, regulated or protected
market position, monopoly position or barriers to entry, market potential, breadth of
appeal, mystique, heritage or longevity,
competitive edge, life-cycle status, uniqueness, discount prices, liquidity or illiquidity
and ownership control.
125
See Morgan, Buy-In Payments and Market
Valuations, 8 TAX MGMT. TRANSFER PRICING REP.
449 (Sept. 15, 1999). See, e.g., Economist
Says E-Commerce Firms Using Cost Sharing
to Cut Uncertainty, 9 BNA TAX MGMT. TRANSFER PRICING REP. 70 (May 31, 2000). See J.
KAGEL AND A. ROTH, HANDBOOK OF EXPERIMENTAL
ECONOMICS, at 446–47 (1995).
126
See A. DAMODARAN, DAMODARAN ON VALUATION: SECURITY ANALYSIS FOR INVESTMENT AND
CORPORATE FINANCE (1994).
127
Levey, Miesel and Gargofalo, Cost-Sharing
Agreements: Buy-In/Buy-Out Payments and
the Valuation Problem, J. INT’L TAX’N, Oct.
2000.
128
Id. For example, these intangibles can
include software licensing rights, knowhow, process technology (R&D-related),
long-term contracts, trademarks, trade
names, dealer networks and customer lists.
The real difficulties arise, however, when
the intangible involves unfinished (“workin-process”) R&D. A traditional valuation
method of discounting projected cash
flows (DCF) to calculate value may be highly
speculative because there may be no cash
flows, historical sales or profits on which to
base projections.
129
That is, a company with valuable product
patents that are unused currently, but which
could produce significant cash flows in the
future may therefore be undervalued using
traditional valuation techniques.
130
Many companies have several different types
of capital issued and are then said to have
a differentiated or structured capitalization.
The total market value of a company’s issued share capital is its market capitalization. “Capitalization” also refers to the act
of converting net retained profits or reserves
into issued share capital.
131
See Wills, Valuing Technology: Buy-In
Payments for Acquisitions, J. G L O B A L
TRANSFER P RICING , Feb. 1999, at 31–32.
The market capitalization method (if
properly used) is generally consistent
with the “residual method” used to
allocate values to groups of corporate
assets, based on seven declining groups
or classes of property, ranging chronologically from the tangible to the generically
intangible class of property or property
right, as used traditionally in Code Sec.
338 acquisitions, as codified in Code Sec.
1060 coupled with Code Sec. 338 and the
regulations hereunder.
132
See generally FSA 200023014 (Feb. 9,
2000). A footnote in the FSA states that
the market capitalization method will be
more useful where the buy-in involves an
acquisition of the intangible to be used
rather than a short-term license, likely for
the reasons noted above. With the high
historical price-to-earnings and marketvalue-to-book multiples seen several years
ago, the IRS examiners were attracted to the
market capitalization method (and resulting
high asset values) despite the many problems
with that approach.
133
See Finan, Reliably Determining a Buy-In
Payment Under Code Section 482, J. GLOBAL
TRANSFER PRICING, Feb. 1999, at 19–20.
134
Reg §1.482-7(h).
135
Code Sec. 170, specifically, Code Sec.
170(c)(1) and (2), (b)(1) and (2).
136
Rev. Rul. 2003-28, IRB 2003-11, 594.
137
Terri W. Cammarano and Richard F. Riley,
Jr., Contribution of Patents, Valuation Remains The Toughest Issue When Donating
Patents, J. TAX’N, Nov. 2003.
138
See Rev. Rul. 59-60, 1959-1 CB 237.
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55