Cross License Agreements under Review by US Tax Authorities; Significant Income and Withholding Tax Questions at Issue

Recent industry group and Congressional letters to Treasury have commented on the importance of CLAs and expressed great concern about potential IRS views of these arrangements.

On March 15, 2006, the Treasury Department and the Internal Revenue Service issued Notice 2006-34 (the Notice)1 requesting public comments on cross license agreements (CLAs). The Notice requests information across a broad range of issues, presents three alternative theories under which CLAs might be characterized and briefly discusses the very significant potential income and withholding tax consequences that would flow from each characterization.

The Notice states that the Treasury and the IRS have “received requests” on the tax treatment of CLAs and that the agencies expect to issue guidance regarding certain tax issues related to CLAs. The Notice does not indicate whether the requests for guidance have been in the context of parties seeking published guidance, private letter rulings or other non-published guidance, for example, in the course of an IRS Examination. Recent industry group and Congressional letters to Treasury have commented on the importance of CLAs and expressed great concern about potential IRS views of these arrangements.2

Cross License Agreements

The Notice describes a CLA as “[a] contract between two parties that own intellectual property, typically patents, under which each party grants to the other a license with respect to specified property. These rights in the respective patents are often licensed on a nonexclusive and nontransferable basis.”

CLAs are common where parties to a prospective licensing agreement have patent rights which the other party wants, or where there is a cluster of patents in a field to such an extent that no individual holder of patents can be certain of not infringing on another's patent rights. By entering into a CLA, each patent holder may operate without fear of being charged with infringement of the rights of the other and without the threat of litigation. Depending on the relative value of patent rights, the exchange of a license and cross license may be accomplished with or without an actual cash payment of royalties.3

US Withholding Tax Rules

The United States has two taxing regimes for US income earned by foreign persons: (i) a 30 percent withholding tax imposed on US source fixed or determinable annual or periodic income, which includes royalties, or (ii) net basis taxation on US or foreign source income that is effectively connected with the conduct of a trade or business within the US. Gains from the sale or exchange of property derived by foreign persons, even if from US sources, are generally not subject to tax in the US unless effectively connected with the conduct of a US trade or business.

The source of royalty income is determined under Sections 861(a)(4) and 862(a)(4), according to the location of use of the subject intangible property.

Three Alternative Characterizations -Tax Consequences

The Treasury and the IRS are considering treatment of CLAs under three alternative theories: (i) Two-Way License, (ii) Reciprocal Agreement Not to Assert Claims of Infringement or (iii) Sale or Exchange of Property.

Two-Way License

The income tax consequences under this theory could include:

• for tax accounting purposes, gross royalty income equal to the full value of the licensed rights plus any cash payment, currently includable, except to the extent of any contingent payments, which would be recognized when accrued or received
• gross deduction or capitalizable expenditure, equal to the full value of the rights conveyed plus any cash payments made
• source determined under Section 861(a)(4) or 862(a)(4), according to location of use
• in the case of a foreign recipient of rights under a CLA, a potential US withholding tax on the full value of the rights conveyed to the foreign person plus any cash payment, to the extent that such income is sourced in the US
  
  

Reciprocal Agreement Not to Assert Claims of Infringement

The income tax consequences under this theory could include:

• income realized limited to cash received or the gross value of any licensed rights under the CLA
• if characterized as reciprocal services, source determined by location where services are performed (withholding tax would also be imposed based on where services are performed)
• tax accounting treatment similar to a Two-Way License, as described above
  
  

Sale or Exchange of Property

The income tax consequences asserted under this theory could include:

• gross income realized in the amount of gain or loss on the exchange of rights and any cash payments made under the license
• possible non-recognition treatment under Section 1031 (in which case an allocation of basis between retained and conveyed rights is required)
• gain or loss sourced where the income recipient resides except to the extent of contingent payments, which are sourced as royalties
• tax accounting treatment similar to a Two-Way License as described above
• for a foreign recipient, no withholding tax except to the extent of contingent payments, which are sourced as royalties