United States: Transfer Payments For Offshored Patents Can Invite IRS Scrutiny And Hinder Patent Damages Claims

Introduction

Tax inversions and the offshoring of intellectual property by U.S. companies grew from an arcane tax law subject to a popular election year issue this autumn. This was partly due to a new IRS program emphasizing the enforcement of existing transfer pricing rules, which are particularly relevant for companies that offshore patents and other IP to foreign corporate entities. Transfer pricing is a significant area of scrutiny for the IRS because transfer payments impact the foreign income of American companies and the amount of tax the U.S. can collect. The IRS emphasis on transfer pricing enforcement is likely to remain after Election Day 2016. Therefore, well-thought-out strategies by tax and IP attorneys for determining transfer payments between U.S. companies and foreign subsidiaries can protect the overall value of the IP assets to the corporate family as well as enable an entity in the corporate family to recover for the damages caused by infringement of offshored patents.

Background

Since the 1990s, American companies have been merging with entities in lower-tax countries and offshoring their IP in exchange for transfer payments to reduce taxes. U.S. corporations have tripled the profits they earn in foreign tax havens by using transfer payments to maximize expenses in the U.S. and maximize income overseas. In response, however, the IRS recently announced its new emphasis on transfer pricing enforcement to address tax avoidance.

In addition, recent Federal Circuit case law has found transfer pricing agreements do not sufficiently reflect the value of the IP transferred. This case law has resulted in dramatically reduced damages for infringement of offshored patents. In Warsaw Orthopedic, Inc. v. Nuvasive, Inc. (Warsaw I), the court held that an offshore patent holder may not obtain the lost profits of a U.S. subsidiary as damages for infringement. This decision was reaffirmed after remand on other grounds in the 2016 case Warsaw Orthopedic, Inc. v. Nuvasive, Inc. (Warsaw II). In Warsaw I, the court also held that while the patentee was entitled to a reasonable royalty for the value of its patents, transfer payments made pursuant to a transfer pricing agreement from a U.S. subsidiary could not be used as a starting place for analyzing the reasonable royalty for the patented technology because the transfer payments did not result from arm's-length negotiations.

Transfer Pricing and Patent Damages

Transfer pricing is the price charged by a company to an offshore subsidiary for intangible property such as patents. See 26 U.S.C. § 482 (allocating income attributed to the transfer of intangible assets between companies). Transfer pricing is a significant area of scrutiny for the IRS because transfer payments impact the foreign income of American companies and the amount of tax the U.S. can collect. To minimize inter-company price manipulation, transfer pricing rules apply an arm's-length standard, requiring IP transactions between subsidiaries be consistent with comparable transactions between unrelated parties. See Treas. Reg. § 1.482-1(a) – (b) (describing the purpose and scope of the arm's-length standard). Therefore, tax inversions invite increased IRS scrutiny of IP transactions because of the complexity of determining arm's-length pricing between related offshore entities.

In a tax inversion, an American company merges with a smaller company in a lower-tax country. Tax inversions drew public attention in 2016, when Pfizer proposed a merger with Allergan to invert to Ireland. Biotechnology and pharmaceutical companies have found that transferring their patents to subsidiaries in lower-tax jurisdictions in exchange for transfer payments can result in profits being taxed at lower rates. However, in addition to increased IRS scrutiny of such patent transfers, the Federal Circuit's 2015 Warsaw I decision could hinder claims for patent damages by a company that has effected a tax inversion, such that its IP is held offshore.

Courts recognize two measures of patent damages: lost profits and reasonable royalties. Warsaw I quoting 35 U.S.C. § 284 (providing for "damages adequate to compensate for infringement, but in no event less than a reasonable royalty"). A patentee may recover lost profits when it can prove that it would have earned those profits in the absence of infringement. See Rite-Hite Corp. v. Kelley Co. (en banc). A reasonable royalty is the alternative measure of damages where a lost profits award is not appropriate or does not fully account for the harm to the patent holder of the infringement. A reasonable royalty, on the other hand, compensates the patentee for the value of what was appropriated (the patented technology). See Warsaw I. This remedy "derives from a hypothetical [arm's-length] negotiation between the patentee and the infringer...." See ResQNet.com, Inc. v. Lansa, Inc.

In an early setback to claims for damages related to infringement of offshored IP, with their 2004 decision in Poly-America, L.P. v. GSE Lining Technology, Inc., the Federal Circuit held that a patent holder may not claim the lost profits of a related U.S. company as its own damages. Poly-America sued GSE for infringement of two patents licensed to Poly-America's sister company, Poly-Flex, which was located in the U.S. GSE conceded infringement, and a jury awarded damages. On appeal, however, the Federal Circuit reversed the district court's damages finding, holding that Poly-America could not claim the lost profits of Poly-Flex because Poly-America did not sell a product embodying the claimed invention, even though it collaborated in such a product's manufacture and sale by Poly-Flex. Although Poly-America was located in the U.S., the Federal Circuit decision would also apply to a foreign patent holder suing for lost profits of a related U.S. company.

Four years later, in Mars, Inc. v. Coin Acceptors, Inc., amended by Mars, Inc. v. Coin Acceptors, Inc. (2009), a patent infringement action related to vending machine technology, the Federal Circuit held that because the plaintiff transferred its entire interest in the asserted patents to its subsidiary in the U.K., the plaintiff was not entitled to recover lost profits and, in fact, lacked standing to sue. On remand, the district court found that the plaintiff could cure standing by transferring ownership of the patents back from its UK subsidiary but the plaintiff was only awarded reasonable royalties of $25 million. Consent Final Judgment After Return of Mandate, Mars, Inc. v. Coin Acceptors, Inc., No. 2:90-CV-00049, No. 428 (D.N.J. Apr. 17, 2009).

The Federal Circuit's Damages Analysis in Warsaw

In 2008, the medical device company Warsaw Orthopedic along with its related company Medtronic Sofamor Danek USA, Inc. (MSD), both located in the U.S., sued Nuvasive for infringement of two patents assigned to Warsaw. Warsaw did not practice the patented technology. Instead, it licensed the technology to its related companies, Medtronic Puerto Rico Operations Co. (M Proc) of Puerto Rico and Medtronic Sofamor Danek Deggendorf, GmBH (Deggendorf) of Germany, which respectively manufactured and sold the patented products to MSD.Deggendorf and M Proc each paid separate royalties to Warsaw on their product sales. Warsaw manufactured non-patented surgical rods and screws ("fixations") for MSD, which packaged them with the patented products into medical kits. At trial, Warsaw attempted to obtain lost profits damages on three sources of income: (1) revenue from the sale of fixations to MSD; (2) royalty payments from M Proc and Deggendorf; and (3) "transfer payments" from MSD to Warsaw to account for the fair market value of property exchanges and implied licenses for various patented technologies between the companies. The district court found that Nuvasive infringed Warsaw's patents and awarded lost profits and a reasonable royalty.

On appeal, the Federal Circuit rejected each of Warsaw's claims for lost profits. The court first noted that a patentee may recover lost profits for convoyed sales (when a non-patented component is sold with a patented product) only if the non-patented component is functionally related to the patented product: "Being sold together merely for 'convenience or business advantage' is not enough." The court found that Warsaw failed to prove the functional relationship necessary for lost profits on convoyed sales of its fixations because including fixations with the patented product was merely for convenience. Therefore, the court rejected the claim of lost profits from sales of the non-patented fixations.

Second, the court noted that under Poly-America, a patentee may not claim the lost profits of a related company as its own damages. "To be entitled to lost profits... the lost profits must come from the lost sales of a product or service the patentee itself was selling." Although Warsaw contended that it was making the sales, and that Deggendorf and M Proc were merely its agents, the evidence did not support this characterization. Therefore, the impact of infringement on Deggendorf's and M Proc's sales was not recoverable as lost profits. The court, however, did not indicate whether Warsaw could have collected lost profits if it had shown that Deggendorf and M Proc were acting as its agents.

Third, the court noted that Warsaw received transfer payments from MSD to reflect the fair market value of property exchanges, management fees and implied licenses regarding other patents. These payments from MSD amounted to 95% of MSD's profits from the sale of the patented products. Regardless, the court found that the decline in the transfer payments was not recoverable as lost profits because Warsaw did not distinguish what percentage of the transfer payments was attributable to the patented technology, as opposed to unrelated transactions. Neither did the transfer pricing agreements distinguish transfer payments on a technology or product basis.

Although the court rejected Warsaw's claims for lost profits, it recognized that Warsaw was at least entitled to a reasonable royalty sufficient to compensate it for the value of the infringed patents under 35 U.S.C. § 284: "the court shall award the claimant damages adequate to compensate for infringement, but in no event less than a reasonable royalty for the use made of the invention by the infringer." The court noted that evidence of royalty agreements entered into at arm's-length can be evidence of the value of a patent. But the Court held that royalties and transfer payments paid by related companies are not probative as to a patent's value because such payments do not result from arm's-length negotiations. In Warsaw I, citing Allen Archery, Inc. v. Browning Manufacturing Co., the court rejected agreements between related parties as establishing a royalty rate because the transactions were not arm's-length. Therefore, the transfer payments from MSD and royalties from Deggendorf and M Proc could not be used as a starting place for calculating the percentage of profits attributable to practice of the patented invention.

Takeaways for Patent Owners and Exclusive Licensees

Tax and IP attorneys advising clients on the offshoring of IP in exchange for transfer payments should consider the following:

• Where the IP offshored is central to the value of a product line and is likely to be enforced against competitors, offshoring it can negatively impact the overall value of the asset to the corporate family. Unless the offshore entity is actually involved in product development, the transfer of the asset is likely to prevent any entity in the corporate family from being able to fully recover for the damages caused by patent infringement.
• Given that offshoring IP is usually part of a larger corporate transaction, where transfer pricing is set for a business or part of a business, recognize that the transfer pricing agreement that does not break out the value of specific IP assets is likely not going to be considered by a court in setting damages using a reasonable royalty framework. An agreement that does break out the value of specific IP assets could come into evidence if it is in line with industry valuations. If it is not in line with industry valuations, it may be excluded as not reflecting an arm's-length negotiation.
• The litigation alternatives to admission of the transfer pricing agreement are either to set separate payments in the transfer pricing agreement for the patented aspects of a product versus non-patented features, or to resign oneself to the admission of arguably non-comparable licenses from other sources. In the absence of evidence of valuation for the specific patent assets, courts will consider evidence of comparable licenses.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.