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Now more than ever, intellectual property makes up a significant part of the value of any business. New technologies and digitized products permit business to flourish in a borderless virtual world. These developments have led to an enormous upsurge in the use and transfer of intellectual property, especially in the international context. These transfers of intellectual property, by licensing or sale, are taxable events � sometimes in more than one country. For the business community, certainty in the treatment of transactions involving valuable intangibles is crucial in planning future operations and business growth. Unfortunately, the needed certainty has been elusive in the tax context. When intellectual property is transferred, the relevant taxes to consider are, at a minimum, U.S. federal income tax, state and local sales taxes, and state and federal excise taxes. In the international context, transfers may also involve withholding taxes, customs duties, value-added taxes, and gross receipts taxes, as well as, potentially, direct foreign income taxation on those having an office or otherwise conducting business within a foreign country. Apart from the multitude of taxes that may be assessed, the principles applied in determining whether a transaction would trigger any such taxes may vary among jurisdictions. Until tax authorities embrace a borderless concept by adopting uniform rules, transactions must be reviewed under multiple tax systems. As a result, it takes considerable effort to correctly characterize a transaction for tax purposes. In many cases, the effort may yield an uncertain result. And taxpayers who are unaware of the nuances may reach the wrong conclusions, generating substantial additional tax liability. OUTMODED PATCHWORK The U.S. Treasury Department has thus far declined to formulate a separate set of tax rules that apply to the exploitation of intellectual property. Although the Internal Revenue Code contains some provisions specifically relating to intangible property of a particular nature or under certain circumstances, such provisions are largely a patchwork and often outmoded. One result is that small changes in facts or circumstances can make all the difference in tax consequences to a company. For example, intangibles acquired in connection with the conduct of a business are generally amortizable over 15 years, but there are many exceptions, depending on the type of intangible property, the type of transfer involved, and the circumstances associated with its acquisition. Typically, companies encounter problems in applying existing tax principles to new transactions, products, and services that lawmakers did not contemplate. Not only have technologies changed dramatically, but commercial activities involving intellectual property have become more complicated. Different classes of intellectual property often overlap and converge with services and tangible property, which often result in different tax treatment. Whether taxes are imposed on a transaction, and which tax authority may impose taxes, depend on the proper characterization of the payments involved, the source of the income, the scope of rights conferred, and the ownership of the intellectual property. Notably, the principles applied in resolving these questions for tax purposes may depart from the legal standards applied for other purposes. The fact that we cannot touch or see intellectual property and that it is often transferred by way of a tangible medium has been the source of uncertainty in reaching the proper tax result. As a threshold matter, lawyers must take care before applying any tax test to properly identify whether the transaction actually involves the transfer of intellectual property, or whether it is simply a transfer of an article with embedded intellectual property that conveys no rights to exploit that property. The appropriate tax may differ depending upon this conclusion. Consider the simple but counterintuitive example of purchasing software by downloading it from the Internet. One might assume that this involves a transfer of intellectual property. That instinct would be mistaken. Computer software that is not impressed on a CD but rather is downloaded for personal use is hard to view as being tangible. Nonetheless, according to prevailing law, online software is taxable in the same manner as shrink-wrap software, based on the rationale that the transfer did not convey any rights to exploit intellectual property. (Although the Internal Revenue Service has resisted definitively classifying shrink-wrap software as “tangible property,” at least one court was not hesitant to do so in the context of a different tax provision.) SALE OR LICENSE? After it is determined that intellectual property is being transferred, the next important issue to consider is whether the transaction involves a license, which generates royalty income, or a sale, which triggers a gain from the disposition of property. Royalties generally produce ordinary income, whereas the gain from the disposition of intellectual property is taxed at a reduced rate (with significant exceptions). Unfortunately, under federal income tax law, the test for determining sales versus licenses is not clearly defined. Some factors of particular relevance are the rights granted and the extent of those rights, such as whether the license is exclusive or nonexclusive, the geographic area in which the rights may be exploited, and the portion of the rights being transferred. The U.S. Supreme Court has held that a sale occurs when a taxpayer transfers “all substantial rights” in that property. This rule has been relaxed somewhat over time so that, for example, the transfer of the exclusive right to use intellectual property throughout its life in a particular medium can be considered the sale of a capital asset. Moreover, the existence of geographic restrictions in the grant of rights in an intangible has been determined not to automatically disqualify the transaction from being treated as a sale. For nontax purposes, some jurisdictions restrict terminations and renewals of licenses beyond the terms of the license itself under certain circumstances, which makes the determination of the duration of the rights conveyed somewhat problematic. Other special provisions can also come into play, such as the statutory rule that treats certain taxpayers’ gain on the transfer of patents (but not other intellectual property) as a sale of a capital asset held for more than one year. There is also the issue of whether a component of the income represents compensation for services associated with the transfer. Other nuances exist with intangible rights that are incidental or ancillary, certain intangibles that are self-created, marketing intangibles, and intangibles that have a readily ascertainable useful life. Taxpayers must also consider whether the license has a fixed duration or indefinite term, and whether the purchase price is a fixed amount per use or percentage of revenue, as opposed to a lump-sum payment. If a disposition produces a loss, this may alter its tax treatment. These are but a few of the circumstances that could result in tax consequences that diverge from the expected result. SUBSIDIARY TRANSFERS Apart from the pitfalls created by the continuing complexities and lack of clarity in the law, a company frequently cannot conduct a comprehensive analysis of a transaction without determining its tax treatment in each country involved, as well as its treatment under U.S. rules specifically for transfers overseas. In conducting a multinational business, it is often desirable for nontax reasons to set up subsidiaries abroad. This may require the transfer of intellectual property to this related party. Payments for the transfer are governed by a detailed set of tax rules that look at what an unrelated party would charge in a comparable transaction under similar circumstances. A penalty of 20 percent or 40 percent, as well as interest, may apply for noncompliance. As to royalties earned by a foreign subsidiary, income is subject to U.S. anti-deferral rules, unless such income is attributable to an active business conducted by the foreign subsidiary and received from an unrelated person or unless other very limited circumstances exist. Moreover, overseas transfers of intangibles by a U.S. taxpayer to any foreign corporation as otherwise tax-free capital contributions or reorganizations will be recharacterized as taxable transactions resulting in ordinary income as a stream of payments over the useful life of the property. When payments are made across borders, the source of the income often determines the tax consequences. The determination of the source first depends on whether the payments are contingent on the productivity, use, or subsequent disposition of the intangible. Back-to-back licenses (e.g., the sublicense of a license) are particularly hazardous, as they may result in double taxation. It is now a decade since the Treasury Department announced that it was exploring whether the existing framework of tax law, both U.S. and international, is well adapted to changing technology. In 1996, the department determined that no major change was needed. The international community largely agreed. In the best of all possible worlds, it might be time for Congress or the Treasury Department to re-examine this conclusion and to explore the formulation of a new set of rules that will clarify and simplify the tax treatment of intellectual property. As a practical matter, however, it may be more realistic to urge incremental changes to the tax law. Besides the usual political restraints on major change, there is a real probability that because of rapidly changing technology, any new legislation or administrative guidance could be obsolete before it ever comes into force. Until there is some major legislative or regulatory change, the vast majority of American businesses will have to struggle with the current range of uncertainties over the tax treatment of intellectual property.
Jacqueline Wong, an attorney admitted to the New York Bar, provides advice in the D.C. office of Womble Carlyle Sandridge & Rice on tax issues involving technology and intangibles, financial products, cross-border transactions, international operations, and other matters. Wong was senior adviser for tax policy at the Treasury Department from 1993 to 1997. She may be reached at [email protected].

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