February 20, 2009

The Internal Revenue Service ("IRS") announced new administrative tax rules for patent licensing arrangements entered into between US and foreign taxpayers; the announcement came via Rev. Proc. 2007-23. The ruling provides a method by which taxpayers may change to, or continue to use, the Net Consideration Method (“NCM”) for qualified patent cross-licensing arrangements (“QPCLAs”).
 
The Rev. Proc. notes that many cross-licensing arrangements are entered into in order to provide the parties the “freedom to operate”—that is the freedom to make use of their own patent or other intellectual property without worry of infringement claims from another party who owns a similar patent. Because taxpayers often enter into QPCLAs in order to avoid costly patent litigation and disputes, and not for the principal purpose of making use of the other parties’ patent, little emphasis is placed on valuing the underlying patents beyond the cash payments made by one party to the other in connection with the agreement, if any. Additionally, determining the source of income for QPCLAs under the international taxation rules under the Internal Revenue Code (the “Code”) can be exceedingly difficult, due in large measure to the lack of objective benchmarks, such as a per-unit royalty payment, which if present facilitate the sourcing inquiry. Due to these difficulties and in the interest of sound and consistent tax administration, the IRS noted that taxpayers are not required to account for amounts other than the net consideration for QPCLAs.
 
A QPCLA 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.” If the agreement between the parties involves more than a de minimis licensing or transfer of other intangible property, the agreement will not qualify as a QPCLA. Analysis of whether a transfer involves more than a de minimis licensing transfer is based on all of the facts and circumstances surrounding the agreement.
 
For the purposes of the Rev. Proc., the term net consideration is the amount of consideration received, other than license rights received by the taxpayer, reduced by the amount of consideration paid by the taxpayer, exclusive of the transfer of license rights and other de minimis intangible property, in connection with the QPCLA. Stated differently, the net consideration is the amount of cash or property received or paid by the taxpayer, other than de minimis intangible property or license rights, as a result of the QPCLA.  
 
If the taxpayer elects to use the net consideration method, only the “net consideration” amount will be subject to the withholding requirements of the Code if the net consideration payment is made to a foreign person. Further, only the net consideration amount will be subject to the capitalization rules under section 263(A) or 263(a), as applicable.  
 
A taxpayer who changes the reporting of a QPCLA to the NCM must note that such a change constitutes a change in the method of accounting under the Code and requires prior approval of the Commissioner. The rules described in the Rev. Proc. are effective for QPCLAs entered into on or after February 14, 2007. Further, the IRS announced that it will no longer contest the use of the NCM for QPCLAs entered into prior to the effective date

CIRCULAR 230 DISCLOSURE
THE DISCUSSION OF TAX CONSIDERATIONS WAS NOT INTENDED OR WRITTEN TO BE USED, AND CANNOT BE USED BY ANY TAXPAYER, FOR THE PURPOSE OF AVOIDING TAX PENALTIES THAT MAY BE IMPOSED BY THE INTERNAL REVENUE SERVICE.  ANY TAX ADVICE CONTAINED HEREIN WAS WRITTEN TO SUPPORT THE PROMOTION OR MARKETING OF THE TRANSACTIONS OR MATTERS ADDRESSED BY THE WRITTEN ADVICE. EACH PARTY SHOULD SEEK ADVICE BASED ON THE PARTY’S PARTICULAR CIRCUMSTANCES FROM AN INDEPENDENT TAX ADVISOR.