United States: IRS Listens To Taxpayers And Limits Taxation Of Patent Cross Licenses

The IRS provided a Valentine’s Day present to companies with patent cross licenses by issuing Rev. Proc. 2007-23, in which the IRS announced limited taxation of such patent cross licensing arrangements. Under Rev. Proc. 2007-23, the IRS announced that a patent cross licensing arrangement in which no cash was exchanged would not be subject to taxation. Importantly, the IRS further announced that it will not pursue any case (whether in an examination, at appeals or before the Tax Court) where a taxpayer used the method described by Rev. Proc. 2007-23 prior to February 14.

An earlier announcement – Notice 2006-34, in which the IRS requested comments, information, and documents on cross licensing arrangements – seemed to indicate that the IRS might subject all cross licenses to tax. Rev. Proc. 2007-23 shows, however, that the IRS was convinced by taxpayer submissions that taxing cross licenses entered into to avoid or settle patent infringement disputes would present administrative problems. In particular, the IRS pointed to difficult valuation and source of income issues. Thus, the IRS determined that in these particular transactions, it would not require taxpayers to take into account any amount other than an actual cash payment. If the IRS had not reached this conclusion and had made patent cross licenses subject to tax, U.S. withholding tax at a 30% rate (unless reduced by an income tax treaty) would be required on every deemed U.S. source payment to a foreign cross licensor even though no cash would actually have been paid.

Rev. Proc. 2007-23 limits its application to a "qualified patent cross licensing arrangement ("QPCLA")," which is a nonexclusive, nontransferable patent cross licensing arrangement among uncontrolled parties, the subject matter of which is limited to the parties’ present or future patent rights. The term "cross licensing arrangement" is defined as a contractual arrangement between two or more parties that own intellectual property, under which each party grants to the other a license of specified intellectual property that is properly characterized as a license under applicable U.S. tax law principles. If, however, the parties engage in more than de minimis licensing or other transfers of intangible property (including copyrights, trademarks, and know how) under the arrangement, the arrangement is not a QPCLA. Whether the licensing or other transfer of other intangible property is de minimis is a facts and circumstances question. The IRS does not provide any further discussion of the de minimis test nor any examples

Under a QPCLA, the "Net Consideration Method" applies. The term "net consideration" means the amount of consideration other than license rights and de minimis other intangible property received by a party to the arrangement, reduced by the amount of such consideration paid. Only the net consideration is subject to withholding. Thus, if no consideration is provided other than the right to use the patents subject to the QPCLA and other de minimis intangible property rights, there will be no U.S. tax consequences. Only if the U.S. party makes a cash payment to a foreign cross licensor will that payment be subject to withholding tax.

The IRS has requested further comments from taxpayers on the definition of a QPCLA and on whether it should extend the Net Consideration Method to other types of cross licensing arrangements and, if so, under what conditions. As an example of such an extension, the IRS specifically requests comments on cross licensing arrangements for the joint development of intellectual property where the parties engage in more than de minimis licensing and transfers of other intangible property.