Tax Update. Cross-Border Cross Licensing The IRS Speaks. Tax Practice Group Welcomes New Partner Ellen McElroy. in this issue

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1 February 2007 Cross-Border Cross Licensing The IRS Speaks The IRS has released guidance on the U.S. taxation of cross-border cross licensing of patents that will be comforting to some taxpayers and problematic for others. It is an issue that is particularly common in the biotech/ pharmaceutical industry. The basic question is whether cross licensing of patents between a U.S. person and a non-u.s. person gives rise to an obligation to collect U.S. withholding tax on payments deemed made to the non-u.s. person. Revenue Procedure applies to cross licenses of patents that are non-exclusive, non-transferable and that do not contain licenses for more than a de minimus amount of other IP, such as copyrights or trademarks. These are referred to as Qualified Patent Cross-Licensing Arrangements (QPCLA). If you have a QPCLA, and the only consideration in the QPCLA is the license of the respective patents, the revenue procedure confirms that there is no U.S. withholding tax. If the agreement contains other consideration in addition to the cross licensing, the overall consideration is netted together; and if the U.S. person has a net obligation to make payments to the non-u.s. person, the net amount in this issue 1 Cross-Border Cross Licensing The IRS Speaks 1 Tax Practice Group Welcomes New Partner Ellen McElroy 3 Renewable Energy Sources: The IRS Goes Green with Section 45 3 Speakers Corner 5 Pepper Hamilton llp Tax Practice Group Tax Practice Group Welcomes New Partner Ellen McElroy Pepper Hamilton llp is pleased to welcome Ellen McElroy, the latest addition to the Tax Practice Group in our Washington, D.C. office. Ellen focuses on a broad variety of issues involving both accounting methods and inventories. She has represented a number of clients in controversy matters, including IRS Exam, Appeals and National Office matters. Before joining Pepper, Ellen was at Ernst & Young LLP, where she led the firm s transaction cost review practice, and worked on accounting methods and inventory matters for Fortune 500 companies as part of her role in the National Tax Department. Before Ernst & Young LLP, Ellen was a Legislation Counsel for the IRS Office of Special Counsel (Legislation), where she developed and drafted legislative proposals, and supervised congressional investigations, and GAO audits involving the IRS. She also was a senior attorney with the Income Tax and Accounting Division of the IRS. In this position, Ellen was the principal author of final regulations under the uniform capitalization rules and temporary regulations involving the deductibility of lobbying expenses. Ellen received her B.B.A. from Emory University. She received her J.D. from the University of Denver College of Law, where she was Law Review general editor. She received her LL.M. from Georgetown University Law Center. She is a member of the Colorado Bar Association and the American Bar Association. She is supervised by principals of Pepper Hamilton llp who are members of the District of Columbia bar. She is vice chair of the ABA Tax Accounting Committee and she has served as the chair of the Capitalization Sub Committee. Ellen is an adjunct professor at Georgetown University Law Center. Please join us in welcoming Ellen to Pepper. She can be reached at or mcelroye@pepperlaw.com.

2 is generally subject to the U.S. withholding tax. This is known as the Net Consideration Method of accounting for the licenses. Example 1: Foreign Corp. and U.S. Corp. enter into a QPCLA. No consideration is payable other than the cross licenses. One might argue, as the IRS has in audits, that the value of each license is a deemed payment subject to withholding. Under the Revenue Procedure, even if a third party could value the licenses, there is no U.S. tax imposed on Foreign Corp. and no withholding required by U.S. Corp. Example 2: Same as example 1, but in addition to the cross license of the patents, U.S. Corp. also is obligated to pay Foreign Corp. $20 million. The $20 million is subject to U.S. withholding tax to the extent it is paid for the right to use Foreign Corp s patents in the United States. U.S. Corp is required to capitalize only the $20 million payment under 263A. Impact on Past Behavior If you have been using another method of accounting for QPCLAs, adopting the Net Consideration Method is a change of accounting. If you are under audit and the IRS has been asserting that withholding is due on the underlying value of the licenses, the IRS should drop the issue if there is a QPCLA and no net consideration. What about non-qpclas? The implication of the revenue procedure is that withholding may be due in non-qpclas. For example, if the cross licenses are exclusive, the general view of the IRS, as expressed in informal discussions, is that the underlying licenses are independent consideration that are subject to withholding. The rationale is that the exclusivity makes the license a valuable right, and it indicates that the parties intend to exploit the patent rather than hold it merely to avoid being sued for infringement. You would value the license grants and deem cross payments to be made. Payments deemed made to the non-u.s. party for the right to use the patents in the U.S. would be subject to withholding tax. The U.S. tax rules clearly do not require payments of cash in order to trigger a withholding obligation. If you have been using another method of accounting for QPCLAs, adopting the Net Consideration Method is a change of accounting. Audit exposure on Non-QPCLAs The IRS has announced plans to audit 100 percent of U.S. payors who are making payments that are subject to U.S. withholding tax. Many cross licenses that may be subject to U.S. withholding tax can be exempt pursuant to a U.S. tax treaty if the appropriate documentation is obtained before the payments are made or deemed made. Absent the correctly completed forms, the tax liability is 30 percent, and it is the liability of the U.S. payor if it has failed to collect the tax from the recipient. While the voluntary compliance initiative has closed, experience has shown that it is frequently better to bring any withholding tax compliance issues to the IRS attention, before it raises them. U.S. companies with existing cross-license agreements should review them to determine their exposure for withholding taxes and any remediation activities that should be undertaken. New cross-license agreements should be scrutinized for potential withholding issues. Author: Joan C. Arnold arnoldj@pepperlaw.com -2-

3 Renewable Energy Sources: The IRS Goes Green with Section 45 As concerns for our nation s energy supply have risen, the federal government has periodically provided incentives to encourage the use of renewable energy sources through a variety of sources. Congress provided for a renewable electricity production credit under Section 45 for electricity produced by a taxpayer from qualified energy resources (wind, closed-loop biomass, open-loop biomass, geothermal energy, solar energy, small irrigation power, municipal solid waste and hydropower) at a qualified facility. Section 45(a) provides that the credit for a taxable year is 1.5 cents (adjusted for inflation) for each kilowatt hour of electricity produced and sold by the taxpayer from qualified energy resources at a qualified facility for a 10- year period beginning after the qualified facility was placed in service. -speakers corner Todd Reinstein will be giving a presentation on current federal accounting methods issues at the Orange County Chapter of the Tax Executives Institute on March 7, 2007 in Irvine, California. David Young will be a panelist speaking on Implications of Valuation from an Income Tax Perspective at the CXO Forum on March 8, 2007 at the Tower Club in Vienna. publications Todd Reinstein s article titled, FIN 48: Will It Be a Roadmap to the IRS, was published in CCH s Federal Tax Weekly. Biomass and Notice Although not as well known as wind or solar-powered energy sources, electricity generated from biomass facilities is considered one of the largest sources of renewable energy in the United States. Biomass is the conversion of plant matter into electricity by incinerating the natural waste products from such matter. Open-loop biomass was added to the definition of qualified energy resources, and open-loop biomass facilities were added to the definition of qualified facilities in Section 45 by the American Jobs Creation Act of 2004 (P.L ). On September 26, 2006, the Internal Revenue Service issued Notice (the 2006 Notice) to address a number of open issues relating to the application of Section 45 to open-loop biomass facilities. The 2006 Notice provides guidance after two years of debate since Congress s enactment of Section 45 to open-loop biomass facilities. The 2006 Notice includes much needed guidance on key issues such as co-firing, netting of electric output and placed in service date. Co-firing For taxpayers, a major area of concern addressed in the Notice is how to treat open-loop biomass plants that cofired qualifying biomass material and qualifying material. The profitability of an energy facility is generally related to the amount of heat embedded in the material that is incinerated. Biomass sources produce a lower amount of heat than conventional fossil fuels. As a result, many biomass facilities need to add non-biomass materials that generate more heat to raise the temperature of the incineration to make them more productive. Prior to the 2006 Notice, it was unclear as to whether a facility that co-fired other material still would qualify for the credit. The 2006 Notice clarifies that electricity produced from open-loop biomass that is co-fired with fuels other than fossil fuels (fossil fuels may, however, be used as part of the start up or flame stabilization process) may separately qualify for the credit. The 2006 Notice explains that if a taxpayer produces and sells electricity from both open-loop biomass and other non-qualifying fuels, the amount of the credit will be determined based on the thermal content of the open-loop biomass as compared to the thermal content of all fuels. When two or more fuels are co-fired to produce electricity, the applicable percentage of electricity that is sold to third parties is the amount that is eligible for the credit. Netting To qualify for the Section 45 credit, the electricity generated from renewable sources must be sold to an unrelated third party. The 2006 Notice interpreted this

4 -requirement by providing that a taxpayer only receives the credit based on its net electricity output sold to unrelated third parties. Many facilities, particularly paper mills, use the renewable energy produced in a biomass facility as an energy source in addition to selling the electrical output to unrelated third parties. These facilities often buy and sell electricity from utilities based on needs for both parties. The 2006 Notice requires that electricity produced from open-loop biomass at any location that is sold by a taxpayer to an unrelated person and either the taxpayer or a related person simultaneously purchases electricity from an unrelated person for use at the same location, the sale of the electricity will be treated as a sale to an unrelated person only to the extent the amount of electricity sold exceeds the amount of electricity purchased. This new provision may limit the amount of credit available to qualified facilities. Period In Service The date a qualified facility is placed in service is critical in determining if the facility qualifies and the credit period. The credit period for a qualifying open-loop biomass facility depends on when the facility was placed in service. For facilities placed in service after August 8, 2005, the credit period is 10 years from the placed-in-service date; and for facilities placed in service after October 21, 2004, and on or before August 8, 2005, the credit period is five years from the placed-in-service date. For facilities placed in service before October 22, 2004, the credit period is five years beginning January 1, The 2006 Notice also provides that if the open-loop biomass facility is an addition or improvement to an existing facility, it will not be deemed to be placed in service after October 22, 2004, if more than 20 percent of the facility s total value is attributable to property placed in service on or before October 22, No Rule Area The 2006 Notice is considered by the IRS to be interim guidance issued pending a formal rule-making project. The Notice states that the Service neither will issue private letter rulings under section 45 with respect to openloop biomass, nor rule under the partnership rules for partnerships claiming the credit. The no-rule position for Section 45 open-loop biomass facilities remains in effect. Pepper Perspective As interest in renewable energy sources rises, taxpayers seeking to develop, operate and invest in qualifying projects may be left in the dark since the IRS is unwilling to provide guidance in the form of private letter rulings for this new area. As a result, taxpayers developing qualifying projects may seek advice from counsel in order to develop a position that will enable the projects to qualify for this new credit. Author: Todd Reinstein reinsteint@pepperlaw.com Subscribe to Future Issues Did someone forward you this newsletter? Receive an electronic or hard copy of the monthly newsletter directly by returning this form by , facsimile or by mail to be added to our mailing list or to update your information. Send to Pepper Hamilton llp, Hamilton Square, 600 Fourteenth Street, N.W., Washington, D.C , Attn: Homeira Ghorbani. (Fax or ghorbanih@pepperlaw.com) Name Title Company Address Phone Fax

5 Pepper Hamilton llp Tax Practice Group Federal and International Tax Issues Annette M. Ahlers Joan C. Arnold James W. Barson Gordon R. Downing W. Roderick Gagné Howard S. Goldberg Benjamin M. Hussa Ellen McElroy** Lisa B. Petkun Todd B. Reinstein Joan M. Roll Leonard Schneidman Laura D. Warren Christian T. Wood* R. D. David Young State and Local Tax Issues Philip E. Cook, Jr Lance S. Jacobs Charles L. Potter, Jr Employee Benefits Issues Jonathan A. Clark David M. Kaplan Andrew J. Rudolph Eric R. Stern *Admitted in Maryland only; supervision by principals of Pepper Hamilton llp who are members of the DC Bar. **Admitted in Colorado only; supervision by principals of Pepper Hamilton llp who are members of the DC Bar. For more information about any of our tax professionals listed, please visit our Web site, The material in this publication is based on laws, court decisions, administrative rulings and congressional materials, and should not be construed as legal advice or legal opinions on specific facts. Berwyn Boston Detroit Harrisburg New York Orange County Philadelphia Pittsburgh Princeton Washington, D.C. Wilmington 2007 Pepper Hamilton llp. All Rights Reserved. This publication may contain attorney advertising. --