Development, Ownership and Licensing of Intellectual and Intangible Properties Including Trademarks, Trade Names and Franchises By William P.

Transcription

1 Development, Ownership and Licensing of Intellectual and Intangible Properties Including Trademarks, Trade Names and Franchises By William P. Elliott Bill Elliott discusses the development, ownership and licensing of intellectual and intangible properties. Included is a discussion of the rules for determining the source of different types of income from intangible property, the tax regime applicable to tax-free transfers of intangible property and the Code Sec. 482 transfer pricing rules. Introduction The United States asserts jurisdiction over international intellectual property transfers by way of the principles for taxing jurisdiction generally known as domiciliary jurisdiction and source jurisdiction, or simply residence and source. Jurisdiction by residence is based on the status of the taxpayer as a citizen, resident or entity organized or managed in the jurisdiction, whereas source jurisdiction is based on the source of income and, in the case of conflicting claims, takes precedence over the concept of residence. The United States asserts the jurisdiction of residence over persons of the United States, including citizens and 2004 W.P. Elliott William P. Elliott, CPA, ABV, CVA, LL.M., is a Domestic & International Tax Partner at Decosimo CPAs in Chattanooga. 21

2 Intellectual and Intangible Properties residents, domestically organized corporations and partnerships, and domestic trusts and estates and accordingly taxes such persons on their worldwide income. The United States asserts source jurisdiction over foreign persons, including nonresident aliens and foreign corporations organized abroad, and taxes them on their source investment income on a gross basis at a 30-percent gross rate, and on certain U.S. source business income effectively connected with the conduct of a trade or business in the United States on a net basis at regular graduated rates. 1 Sections 861 through 865 of the Internal Revenue Code ( the Code ) furnish the rules for determining source of income, which are generally applicable, for different reasons, to both foreign persons and U.S. persons. For foreign persons, these source rules govern the scope of the United States exercise of its source jurisdiction to tax certain domestic source income of foreign persons. For U.S. persons (over whom the United States exerts jurisdiction by residence to tax worldwide income), these source rules are primary factors incident to the computation of the foreign tax credit allowed by the Code to mitigate or alleviate the potential double tax on income asserted by the United States and based on a U.S. domicile, and taxed by a foreign country and based on the foreign source of the income. Generally, both foreign and U.S. persons prefer to characterize income as foreign source. 2 Under Code Sec. 865, the source of income from a transfer of intellectual property is determined by the characterization of the transaction as a sale for fixed payments, a sale for contingent payments, a sale of depreciable personal property, a nonsale license or personal compensation. I. Intellectual Property Transfers and Source of Income A. Source of Income Rules The purpose of the source rules is to assert the United States source jurisdiction to tax income that has sufficient and reasonable nexus with the United States. Two convenient tests exist to establish the necessary nexus to justify the exercise of source jurisdiction: Business activities test. The business activities test determines that the source of income derives from the country in which an income-producing activity is conducted. Utilization test. The utilization test determines that the source of income is from capital or property. Thus, the source is the country in which the capital or property is used. These source rules, however, are extremely broad and consequently are not so practical to use in providing independent characterization criteria for determining whether an international intellectual property transfer should receive sale, license, personal compensation or other tax treatment. Inevitably, one is forced to seek other guidance and resort to the Code for other characterization rules that can apply the source rules by analogy, taking into account the particular source rule and the type of transaction. The IRS has adopted a regulatory position that a sale for purposes of the 30-percent gross tax on investment gains 3 includes a Code Sec sale or exchange giving rise to capital gains for patent transfers. 4 Code Sec. 865 (added by the 1986 Tax Reform Act) determines the source of income from sales of personal property by reference to the residence of the seller as its general rule, 5 and Code Sec. 865(d)(1)(A) applies to sales of intellectual property for noncontingent or fixed payments under the general residence of the seller rule. 6 B. Fixed Payment and Contingent Sales A sale for a fixed payment is perhaps the least common method for transferring intellectual property, since an owner of intellectual property typically can maximize the value of intellectual property through licenses or sales with consideration contingent on the level of exploitation or use of the property. 7 The general rule regarding the characterization of a sale for source rule purposes is that a sale, following patent sale principles by analogy, requires the transfer of all substantial and valuable rights in the intellectual property for the legal life of the intellectual property. The sale versus license characterization issue arises most frequently in the patent area. In general, under Code Sec. 1235, a sale of a patent requires a transfer of all substantial rights in the patent or an undivided interest in such rights for the legal life of the patent. 8 The substantial rights in a patent include the right to make, use and sell the patent, and the courts and the IRS have applied the patent sale principles by analogy to copyrights, trade secrets, know-how and trademarks. 9 22

3 The Code imposes a 30-percent gross tax, subject to withholding at source, on certain fixed or determinable annual or periodic investment income paid from U.S. sources to nonresident aliens and foreign corporations, which is not effectively connected with the conduct of a U.S. trade or business 10 and which the Regulations thereunder exclude from coverage the income from sales of intellectual personal property for fixed payments. 11 This consequently renders the 30-percent gross withholding tax to fixed payment sales of intellectual property inapplicable. Further, assuming a foreign person s fixed payment sale of intellectual property is not effectively connected with the conduct of a U.S. trade or business, this sale is exempt from tax, regardless of the sourcing rules. However, a foreign person s fixed payment sale of intellectual property is effectively connected with the conduct of a trade or business in the United States and is taxed on a net basis, accounting for deductions, at regular rates under Code Sec. 871(b) or Code Sec. 882(a). An exception to the general residence of the seller source rule for personal property sales exists under Code Sec. 865(d)(1)(B), which determines the source of contingent payments from the sale of intellectual property as if such payments were royalties, while in turn Code Sec. 861(a)(4) and Code Sec. 862(a)(4) determine the source of royalties paid for the use of intellectual property by place of use, allowing the United States to justify jurisdiction by source by the assertion of sufficient nexus, as the country where the property is used or exploited is the strongest source for taxing such intellectual property income. The Code also imposes a 30- percent gross tax, subject to withholding at source, on the gain component of U.S. source contingent payment sales of intellectual property, paid to nonresident alien individuals and foreign corporations, and which is not effectively connected with the conduct of a U.S. trade or business. If the source of a foreign person s contingent payment sale of intellectual property is the United States and is effectively connected with the conduct of a U.S. trade or business, then the Code taxes it on a net basis at regular rates. 12 The Treasury regulations governing the 30-percent gross tax on investment gains from contingent payment sales of intellectual property contain a unique regime for basis recovery, whereby full basis recovery is allowed from the earliest payments received prior to taxing the gain element of U.S. source contingent payments from such sales. 13 This immediate basis recovery method differs significantly from the basis recovery methods that the IRS requires for contingent payments reported under the installment method with the net effect that gain recognition is accelerated for such contingent installment payments by treating only a portion of each payment received as basis recovery. C. Depreciable/Amortizable Property In another exception to the general residence of the seller source rule for sales of personal property, Code Sec. 865(c) also determines the source of gains from the sale of depreciable personal property to the extent of prior depreciation adjustments, pursuant to a recapture matching principle. In particular, Code Sec. 865(c)(1) places the source of such gains, to the extent of prior depreciation adjustments, by reference to the source of income (U.S. source or foreign source), against which the sellers offset the depreciation giving rise to the gain. Thus, gains arising from depreciation that offset U.S. source income generate U.S. source gains. Correspondingly, gains arising from depreciation that offset foreign source income generate foreign source gains. Code Sec. 865(c)(2) places the source of gains from the sale of depreciable personal property in excess of such prior depreciation adjustments under the place of title passage rules applicable to inventory. In analyzing the potential application of the Code Sec. 865(c) depreciation recapture rule to intellectual property, the extent to which different types of intellectual property are depreciable should be considered. In general, Code Sec. 167 authorizes depreciation of those intangible assets that have a limited useful life, which can be estimated with reasonable accuracy. 14 Thus, patents are depreciable under Code Sec. 167 at least over their 17-year legal lives, or, in the case of design patents, their 14-year legal lives. Similarly, copyrights are depreciable at least over their legal lives, 15 with trade secrets and trademarks generally being ineligible for depreciation because they have theoretically unlimited useful lives. In the case of fixed payment sales of intellectual property by a foreign person not effectively connected with the conduct of a U.S. trade or business, the application of the Code Sec. 865(c) recapture principle has no tax effect. The Code exempts such sales from tax, whether U.S. source or 23

4 Intellectual and Intangible Properties foreign source, because they have an insufficiently high net income content. Contingent payment sales of intellectual property by a foreign person not effectively connected with the conduct of a U.S. trade or business create foreign source income that is exempt from tax since, absent a U.S. trade or business, depreciation generating gain from such sales probably will be offset by foreign source income. 16 In the case of sales of intellectual property by foreign persons effectively connected with the conduct of a U.S. trade or business, the application of the Code Sec. 865(c) recapture principle creates U.S. source business income taxed on a net basis for gains attributable to that depreciation offsetting U.S. source business income. Finally, in the case of U.S. persons, the application of this recapture principle to sales of intellectual property creates U.S. source income that has no foreign tax credit benefit for gains attributable to that depreciation offsetting U.S. source income, even if the person sells the property exclusively for use abroad in circumstances that would otherwise generate foreign source income under Code Sec. 865(d). 17 D. Property Sales Source Rule May Govern Code Sec. 865(e)(2), enacted as part of the 1986 Tax Reform Act, is perhaps the single most important personal property sale source rule applicable to foreign persons, as it overrides the Code Sec. 865(a) general residence of the seller rule, the Code Sec. 865(b) inventory place of title passage rule, the Code Sec. 865(c) depreciation recapture rule and the Code Sec. 865(d) intellectual property rules. Further, it determines the source to be U.S. when any income from the sale of personal property, including intellectual property and inventory property, is attributable to a fixed place of business maintained in the United States, 18 which office is, in and of itself, a material factor in the production of income. 19 Thus, in analyzing the source of income from any transfer of intellectual property having international aspects, one should first determine whether any of these overriding source rules apply to determine the source. II. Transfers of Intangible Assets 20 Between Associated Enterprises 21 A. Assessment of Royalty or Super Royalty? The Code imposes special rules on certain transfers of intellectual property by/between related persons who are subject to special rules that limit the ability of U.S. persons, in an effort to avoid current taxation and obtain tax deferral or effective tax exemption for income attributable to intellectual property, to shift income to foreign entities that are exempt from U.S. taxation. Code Sec. 367(d) recharacterizes contributions of intellectual property by U.S. persons to the capital of foreign corporations in otherwise nonrecognition transactions under Code Sec. 351 or Code Sec. 361 as deemed sales, creating deemed annual royalties. Additionally, Code Sec. 482 creates so-called super royalties on transfers, sales or licenses of intellectual property between related parties and requires the allocation of such royalties to the transferor in an amount equivalent with the income attributable to such intellectual property. The principal difference between a Code Sec. 367(d) deemed royalty and a Code Sec. 482 deemed royalty is that the former automatically creates U.S.-source income 22 while the latter creates income determined by the place of use of such intellectual property under the general source rules. 23 Capital contributions of intellectual property by U.S. persons to foreign corporations in otherwise nonrecognition transactions under Code Sec. 351 or Code Sec. 361 are recharacterized under Code Sec. 367(d) as taxable contingent payment sales, creating deemed annual royalties over the useful life of the contributed property. Further is the requirement, harsh though it may be, that Code Sec. 367(d) incorporates the super royalty concept 24 and is applicable to contributions of intangible property, defined broadly to include any: patent, invention, formula, process, design, pattern or know-how; copyright, literary, musical or artistic composition; trademark, trade name or brand name; franchise, license or contract; method, program, system, procedure, campaign, survey, study, forecast, estimate, customer list or technical data; or any similar item that has substantial value independent of the services of any individual 24

5 but excludes goodwill and going concern value. 25 Notably, Code Sec. 367(d) is not applicable to certain copyrights and similar property produced by a taxpayer s personal efforts described in Code Sec. 1221(3), as such property is a tainted asset, and any built-in gain is taxed immediately under Code Sec. 367(a) upon contribution to a controlled foreign corporation rather than taxed annually under Code Sec. 367(d). 26 Further, Treasury Regulations provide that Code Sec. 367(d), rather than Code Sec. 482, applies to a U.S. person s transfer of intellectual property to a related foreign corporation without consideration. The hypothetical royalty assumes a taxable sale of the intellectual property to the controlled foreign corporation (CFC) in return for a contingent royalty payable annually over the useful life of the intellectual property and joined at the hip to the income from the property. The tax consequences of the deemed receipt of annual U.S. source deemed super royalty income under Code Sec. 367(d) are extremely harsh; its practical effect is to force multinational enterprises (MNEs) to license or sell their intellectual property, even if to related parties subject to recharacaterization under Code Sec. 482, in an effort to avoid the adverse consequences of an encounter with brutal outbound consequences of Code Sec. 367(d). B. Super Royalty Provision and Code Sec. 482 The super royalty provision of Code Sec. 482 provides that, in the case of any transfer or license of intangible property, the income with respect to such transfer or license shall be commensurate Illustration 1 The principal difference between a Code Sec. 367(d) deemed royalty and a Code Sec. 482 deemed royalty is that: A Code Sec. 367(d) deemed royalty automatically creates U.S. source income, and A Code Sec. 482 deemed royalty creates income determined by the place of use of such intellectual property under the general source rules. Code Sec. 367(d) Deemed Royalty U.S.- Source Income Source = Place of use TRANSFERS OF INTANGIBLE ASSETS BETWEEN ASSOCIATED ENTERPRISES Code Sec. 482 Deemed Royalty with the income attributable to the intangible. Effectively, this recharacterizes related party transactions on an arm s-length basis, 27 and creates a problem with respect to the valuation of intellectual property by mandating that cost-plus contract manufacturer relationships between related parties will be deemed to constitute an ineffective assignment of income by the transferor. By further mandating a look-back requirement, the super royalty provision requires transactional maintenance by necessitating a Illustration 2 Transfers of Intangible Assets Between Associated Enterprises Code Sec. 367(d) recharacterizes contributions of intellectual property by U.S.persons to foreign corporations in otherwise nonrecognition transactions under Code Sec. 351 or Code Sec. 361 as deemed sales creating deemed annual royalties. U.S. Person INTELLECTUAL PROPERTY Foreign Corporation DEEMED SUPER-ROYALTY DEEMED ROYALTY Related Party Additionally, Code Sec. 482 creates so-called "super royalties" on transfers, sales or licenses of intellectual property between related parties and requires the allocation of such royalties to the transferor in an amount equivalent with the ncome attributable to it. 25

6 Intellectual and Intangible Properties continuous re-evaluation of the adequacy of intellectual property royalties in related party transactions. And to complicate matters further, the super royalty provision turns on whether such intellectual property is in existence or owned by the sale. Thus, in inbound licensing transactions, a foreign licensor s royalty income generally will constitute U.S.-source income under the place of use rule, subject to a 30-percent gross tax. For outbound international transactions, a U.S. person should never contribute intellectual property to the capital of a controlled foreign corporation in a Code Sec. 351 or Code Sec. 361 nonrecognition transaction that triggers the harsh rules of Code Sec. 367(d). Further, the potential adverse effects of the Code Sec. 482 super royalty provision should be evaluated before transferring intellectual property to related foreign entities. Alternately, the Code Sec. 482 super royalty provision can serve to mitigate adverse tax effects by, for example, having a foreign affiliate develop or purchase intellectual property directly and then sell or license such property back to the U.S. parent corporation in such a way that any Code Sec. 482 allocation will constitute foreign source income to the foreign subsidiary transferor. III. Transfers of U.S.-Based Intellectual Property to Related Entities A. Background As discussed in the preceding section, a person owning intangible property may transfer ownership or use to a related person by means of: a sale; a license; an exchange for an ownership interest (e.g., stock of the related person); a contribution (e.g., a capital contribution to the related person); or an exchange for other property (e.g., a swap of rights under one patent for rights under another patent). If the related person is a foreign corporation, 28 then each of these transfers has the potential for shifting future income to an entity that pays no (or limited) U.S. taxes, while at the same time, a transfer by foreign persons to a controlled U.S. corporation has the potential for draining income from that corporation in the form of excessive royalties. Two primary Code sections limit the shifting of income through the transfer or licensing of intangibles. Code Sec. 482 generally applies to a sale or license to a controlled entity, and Code Sec. 367(d) generally applies to (1) an exchange by a U.S. person for foreign stock that would otherwise qualify under Code Sec. 351 or (2) a capital contribution to an 80-percent controlled foreign corporation. 29 If a transaction takes the form of an actual sale or license by a U.S. person to a related foreign corporation, then Code Sec. 482 applies, and Code Sec. 367(d) will not apply unless the sale or license is a sham, with the form chosen by the taxpayer often controlling which set of rules applies. B. License vs. Sale Differentiating a sale from a license for federal income tax depends on the extent to which the transferor maintains proprietary rights in the underlying property after the transfer is completed, with the greater the transferor s ongoing dominion and control over the property, the less likely the classification as a sale. Of course, classification as a sale means basis recovery and capital gains instead of ordinary income, at least with respect to any gain attributable to lump sum or other, fixed consideration. Alternately, classification of the transfer as a license results in ordinary income to the transferor and precludes basis recovery on the transfer, although the license classification does defer the recognition of proceeds received for the use of its property. Of course, this issue has little or no impact on the tax treatment of the transferee, whose cost recovery of the consideration paid for the property depends mainly on whether such consideration is fixed or contingent. Fixed payments made by the transferee are amortizable over a 15-year period, whereas contingent consideration generally is deductible currently. Congress early remedied historical confusion over the transfer of certain intangible assets, namely franchises, trademarks and trade names, in enacting Code Sec as part of the Tax Reform Act of As enacted, Code Sec sets forth two rules applicable to the transferor, the first providing that a transfer of a franchise, trademark or trade name does not constitute a sale or exchange of a capital asset if the transferor retains any significant power, right or continuing interest with respect to the subject matter of the franchise, trademark or trade name. 31 Such a significant power, right or continuing 26

7 interest for this purpose includes the right to: disapprove any assignment of the transferred interest in the property or any part of such interest; terminate the agreement at will; prescribe quality standards for products used or sold and services rendered; and, for the equipment and facilities used to promote such products or services, require the transferee to: sell or advertise only products or services of the transferor, and buy substantially all its supplies and equipment from the transferor, or receive payments contingent on the productivity, use or disposition of the subject matter of the property interests transferred, if such payments represent a substantial element of the transfer agreement. 32 The second rule, which applies to transferors, involves contingent consideration. As such, the transferor is deemed to have received such consideration from the sale Illustration 3 License vs. Sale or other disposition of property which is not a capital asset. 33 Fixed consideration can trigger either ordinary income or capital gains. Fixed consideration for this purpose means any consideration not measured with reference to the subsequent use, productivity or disposition of the transferred property. It can take the form of a lump-sum payment at closing, or it can be a series of fixed amounts to be paid over time. C. Early Case Law and Legislative History Since the enactment of Code Sec. 1253, one particular case has highlighted the ambiguous nature of the statute. In Tomerlin Trust, 34 the U.S. Tax Court questioned the scope of Code Sec by reverting to prior case law to resolve a sale versus license question. The ambiguity of the statute coupled with the decision in Tomerlin Trust renders the legislative history significant in addressing the federal income tax treatment of franchise, trademark and trade name agreements, as its considerable discussion is indicative of the confusion that existed in the courts. Prior to the Differentiating a sale from a license for federal income tax turns on the extent to which the transferor maintains proprietary rights in the underlying property after the transfer is completed: TRANSFEROR LICENSE & ROYALTY PATENT TRANSFEREE The greater the transferor's ongoing dominion and control over the property, the less likely the classification as a sale. enactment of Code Sec. 1253, state law was already in disarray as evidenced by a series of five appellate cases dealing with transfers of franchise rights, 35 with each of these cases having similar fact patterns and each involving the transfer of long-term and territorially exclusive franchise rights, fixed and contingent consideration, and the transferor s retention of rights as to quality control and other matters. In the first of these cases, the Tenth Circuit ruled that the transfer was a sale regarding both lump-sum and contingent payments, and further found the rights retained by the transferor, such as quality control, store design, financial audit, control over transferee s supply and termination of the agreement, to be conditions subsequently designed to protect the rights of each party. Accordingly, the court found that such rights did not reserve for the transferor an ongoing, proprietary interest in the franchise transferred. In the second case, the Fourth Circuit ruled that the transfer was a sale and that the lump-sum consideration was an amount realized, but treated the contingent consideration as royalties, emphasizing that the transferee s rights were perpetual and that that certain restrictions on quality control and on the transferee s product line protected the product and brand name. However, these limitations did not give the transferor a substantial right in the property transferred. The third case involved two sets of contracts, and, therein, the Fifth Circuit emphasized the perpetual and exclusive nature of the transferee s rights, and ruled that each set of contracts resulted in a sale, at least with respect to 27

8 Intellectual and Intangible Properties the lump-sum consideration paid at closing. 36 The fourth case had identical facts as, and involved the less fortunate brother of the transferor in, the Fifth Circuit decision, but went before the Ninth Circuit, which was in accord in part and disaccord in part with the Fifth Circuit. The Ninth Circuit found rights retained by the transferor in one type of contract to be only protective in nature and therefore insufficient to prevent sale classification. 37 In the final Dairy Queen case, the Eighth Circuit ruled that the transfer was a license with respect to all consideration. 38 Thus, five different Dairy Queen cases on relatively similar facts produced a split of authority: the enactment of Code Sec. 1253, the exclusive means for determining whether the transfer is a sale or license for federal income tax purposes. Since Tomerlin Trust, however, the Tax Court has relied on and applied Code Sec to evaluate rights retained by transferors. Stokely USA, Inc. 39 involved a trademark transfer agreement under which the taxpayer paid a lump sum in exchange for an interest in Stokely s, Stokely s Finest and other trademarks for perpetual use in marketing and selling food products in certain locations. The taxpayer s use of the trademarks was nonexclusive in some jurisdictions, and the taxpayer could not use the trademarks on any porkand-beans products for 20 years. The transferor could disapprove any assignment of the taxpayer s interest in the trademarks for five years. The court in Stokely stated that Congress sought to enact a simple, uniform method for determining the tax treatment of the transfer of a franchise, trademark or trade name and accordingly rules as such to cite Code Sec and the legislative history, not prior case law, in determining whether rights retained by the transferor were significant. Nabisco Brands, Inc. 40 involved an agreement for the transfer of Life Savers and other trademarks. Under the agreement, the taxpayer paid a lump sum at closing and agreed to make annual payments for 10 years based on a fixed minimum and then on the amount of sales attributable to the trademarks. As it did in Stokely, the Tax Court in Nabisco went directly to Code Sec to determine whether the transferor s retained rights and interests in the property were significant and did not apply pre-code Sec case law in this regard. Other courts have read Code Sec as having replaced prior common law on the sale versus license and related issues, as the Fifth Circuit did in Resorts International. 41 In this case, the Fifth Circuit stated that Congress intended Code Sec to be the definitive test of sale versus license classification. In Consolidated Foods, 42 the Seventh Circuit stated that Congress enacted Code Sec to provide uniform treatment of the issue. Although regulatory pronouncements by the Treasury have not been consistent, the IRS has consistently applied the statute as the sole source of authority for ruling on the tax effect of the transfer of franchises, trademarks and trade names, promulgating numerous administrative rulings in this regard. In its rulings, the IRS apparently has not reverted to pre-code Sec case law. 43 Thus, based on the legislative history, case law and administrative pronouncements, it would seem prudent reasoning to view Code Sec as the sole authority for determining whether the transfer of a franchise, trademark or trade name is a sale or a license. Further is Congress reasoning that the transferor s retention of significant rights in the property is inconsistent with sale treatment and serves to classify the transfer as a license. 44 D. Tax Treatment of Transfers with and Without Retention of Significant Rights Where the transferor retains a significant right, the transaction generally is treated as a license and not as a sale of an ordinaryincome asset. The transferor s tax treatment on the grant of a franchise, trademark or trade name depends on the extent of the rights it retains in the underlying property, such that if the transferor retains significant rights, the transfer should not be a sale; it should be a license. Assuming the transferor of a franchise, trademark or trade name does not retain a significant right, the transfer should be a sale, with the transferor computing gain or loss under Code Sec The fixed or contingent nature of the consideration could be a distinguishing factor in the treatment of the transferor, as with respect to contingent consideration, the transferor is deemed under Code Sec. 1253(c) to have received amounts from the sale or other disposition of property that is not a capital asset, thus ensuring that ordinary income and not capital gains rates apply to contingent consideration. As most transferors have no adjusted basis for tax purposes in the transferred property either because the property is self-developed or because the transferor succeeded to its prop- 28

9 erty rights by way of a license in the first place, for such transferors with tax basis in the property, the issue becomes one primarily of basis recovery. If sale treatment extends to this portion of the transaction, then the contingent payments are includable in the transferor s amount realized for purposes of installment method calculations, which defers the transferor s recovery of its tax basis in the property, perhaps materially. Alternatively, if license treatment applies to this portion of the transaction, the contingent payments would be royalties and the transferor would have no basis recovery but would recognize this income over time as it earns the payments under the terms of the transfer agreement. Finally, as to the transferee, two major rules provide for a fairly clear determination of the cost recovery of the consideration paid for the franchise, trademark or trade name, as the transferee s tax treatment does not depend directly on the sale versus license classification but rather on the fixed or contingent nature of its payments. Contingent consideration 45 typically is deductible in full, while lump sum and other, fixed consideration generally is chargeable to capital account and is amortizable by the transferee over a 15-year period. 46 In regards to the right to receive contingent payments (Code Sec. 1253(b)(2)(F)), the amount of such payments relative to total consideration must be substantial in order to avoid sale treatment. Based on the Tax Court s decision in Nabisco Brands, 25 percent of the total consideration received should be a good barometer in this regard. As to retained rights not specifically listed in Code Sec. 1253(b)(2), the issue turns to their materiality and value: the greater the materiality and value of such rights, the greater the likelihood of classifying the transfer as a license and not a sale. Finally, the extent or total number of rights retained by the transferor is important, as only one right falling within the requirements of Code Sec. 1253(a) or Code Sec. 1253(b)(2) should be sufficient to trigger license treatment, as no equitable, de minimus-type exception should prevent a transaction from being a license simply because the transferor retains only one significant right. A transferor desiring sale treatment must limit its retained interest accordingly, and it would seem worthwhile to include in the transfer agreement several rights listed in Code Sec. 1253(b)(2), especially where one of the potentially significant retained rights is the right to receive contingent payments, because the parties may not be able to project with high probability whether the ultimate amount of contingent payments will be substantial relative to total consideration. IV. MNEs 47 and the Development, Ownership and Licensing of Trademarks and Trade Names A. Introduction In a period where the prices that companies can charge for their goods and services are permanently under pressure, it appears that only companies that have valuable intangibles can actually offer unique products and services and thus escape the continuing process of price erosion. This explains why large companies in particular perform much better financially: They appear to be the preeminent owners of distinctive intangibles, particularly strong brand names, with the rapidly increasing significance of trademarks and other intangibles giving rise to the necessity or desirability of including the value of trademarks developed by a company itself in that company s annual accounts. A trademark s commercial exploitation on an international scale obviously has major cost advantages, as international groups are ideally positioned to develop and exploit trademarks in a regional or global context and can introduce a successful trademark that was developed locally in other markets. In various countries, the financial significance of trademarks to trade and industry, and in particular the above-described tendency towards the development and use of trademarks on a regional or even global scale, has led to detailed tax rules, including the U.S. transfer pricing rules and the OECD transfer pricing guidelines. B. Marketing Intangibles The OECD Guidelines divide commercial intangibles into two main categories: trade intangibles, often created through costly and risky technological research and development activities, and marketing intangibles. 48 The Guidelines describe the concept of trademark : A trademark is a unique name, symbol or picture that the owner or licensee 29

10 Intellectual and Intangible Properties may use to identify special products or services of a particular manufacturer or dealer and, as a corollary, to prohibit their use by other parties for similar purposes under the protection of domestic or international law. As the OECD Guidelines note, the exclusive position with regard to the use of a trademark is to be distinguished from the monopoly position that is created for the owner of a patent: Patents may create a monopoly in certain products or services whereas trademarks alone do not, because competitors may be able to sell the same or similar products so long as they use different distinctive signs. 49 A trade name or group name can be at least as valuable for the sale of goods and services as a trademark and sometimes, such trade name or group name is not also used as a service or product mark, although the use of the group name may bring a group company major advantages that justify a fee and necessitate protection against the use by others. It is not clear why such a good (the name of a reputable group) should be made available to newly incorporated group companies for no consideration; however, emphasis should be on whether a value-adding good is being made available and not on whether such a good may be given in use outside the group context. The OECD Guidelines stress the importance of the availability of a specific service to certain group companies; it is quite likely that in many instances an unrelated party would be willing to pay a fee, even if it could gain only an incidental benefit from a service provided directly to a third party. Another category consists of group names that are also used as trademarks for the group s products and services. Under this view, there is no room for a fee for the use of the group name/mark if the trade name laws offer protection against infringements, but such an approach does not promote an economically responsible manner of profit allocation within the group A fast-growing, in-between category is one in which the group name is used besides the specific service or product trademark not only with the specific product mark, but also to feature prominently the group name, perhaps as a seal of guarantee for quality. The responsibility thus taken by the group for the quality of its brand-named products is extremely important to the group company/licensee concerned about the positioning of the products in relation to other products, with the group name being used as a general trademark name besides the trademark name attached to the specific product. As with all intellectual property rights, the object of ownership (the trademark) is a creation of the law of the state concerned, which creates an exclusive position for the qualifying applicant through registration of the trademark, meaning that use and exploitation of the idea or concept is granted to it exclusively. Without the recognition, and more importantly the statutory protection of the trademark in a state s legal system, there is no ownership and thus no value, and, due to the inseparable tie between the intellectual property law of a certain state and a trademark, there may be several owners of a single trademark in different jurisdictions. The group company that lawfully registers a trademark in the relevant jurisdiction should be regarded as the legal owner of a trademark. From a strictly legal perspective, the granting of a royalty-free, exclusive, freely transferable, perpetual license to a local group company does not make the licensee the owner of the trademark. Finally, under the laws of most countries, the trademark holder is permitted to transfer a trademark separately from the transfer of the operating business whose products or services were protected by the trademark. 50 In some jurisdictions, major trademark law impediments may interfere with the centralization of ownership of trademarks within the group. 51 Naturally, a party other than the legal owner of a trademark may acquire an interest in that trademark that represents a value to it. A licensee, for example, may acquire rights in relation to a trademark that are so extensive that the licensee can be regarded as the beneficial owner (or tax owner ) of a trademark in a certain jurisdiction. The content, and in particular the meaning, of the concept varies with each jurisdiction, and to this end, the licensee must acquire the exclusive right to use a trademark in a jurisdiction during a period that (almost) coincides with the expected economic life of the trademark. The form of the fee is not necessarily decisive as a fixed sum that is periodically due, for the term of the license need not interfere with the transfer of the beneficial ownership. On the other hand, a once-only fee for a short-term license will fail to effect the transfer of beneficial 30

11 ownership. Beneficial ownership is involved if the licensee has acquired virtually all of the rights to a trademark, and the legal ownership remains with the licensor only to secure the one-time or fixed periodic fee (purchase price) payable by the licensee. The retention of legal ownership that does not serve as security for the vendor, but enables him, for example, to influence the licensee s behavior, often will not result in the licensee s beneficial ownership of the trademark. There is a very wide range of conditions subject to which a licensee, in different degrees, can acquire an interest in a trademark from the legal owner or from third parties without such an interest being equated with beneficial ownership of the trademark, and this does not affect the possibility that the acquired rights must be regarded as a capital asset by the licensee, it also being possible that the licensee itself makes substantial investments in the further development of a trademark Trademark licenses represent the permission to perform certain acts with regard to a certain trademark and generally fall into the categories of (1) an exploitation license and franchising, (2) a usage license or (3) a distribution license. If the owner of the trademark is also the seller of the products (the usage and distribution license), the question arises whether the fee for usage of the trademark must be included in the price of the products or can be paid separately, as a royalty, but, from the perspective of profit allocation, the only relevant point is that the fee is paid once. With a usage license, the licensee often will pay the fee separately, and with a distribution license, the fee often will be included in the price of the goods supplied. The guidelines do not appear to be relevant to trademark licenses, as the trademark itself is irrelevant or hardly relevant to the manufacturing of the goods and fulfills its role only when the finished goods are marketed, and, generally speaking, the arm s-length principle s only consequence can be that a separate fee from the licensee for the use of the trademark must be possible. In that event, the price of the goods supplied must equal that of unbranded goods. C. Current U.S. Regulations/ OECD Guidelines The regulations are based on the predominant importance of the legal ownership of the mark, with the final regulations adopting a modified approach to the identification of the owner of an intangible that is more consistent with legal ownership. Under the legal ownership, the right to exploit an intangible will be considered the owner for purposes of Code Sec. 482, 52 but legal owner of a right to exploit an intangible does not refer exclusively to the legal owner of the trademark. 53 The regulations, while attributing the interest in the value development of the trademark to the legal owner, apply a special definition of legal ownership, as the legal owner of a right to exploit an intangible ordinarily will be considered the owner for purposes of this section. Such legal ownership may be acquired by operation of law or by contract under which the legal owner transfers all or part of its right to another. 54 The regulations most important conclusion is that not even the acquisition of a substantial part of the relevant rights makes the licensee the owner of the trademark, as transfer of the ownership of the trademark to the licensee should be involved, at least for tax purposes, only if the licensee acquired nearly all of the essential rights for the market in question. 55 In 1996, the OECD published new guidelines that specifically deal with the situation where a licensee pays the costs involved in the promotion (marketing) of a trademark (or a trade name) on the local market and further raise the question whether the marketer (licensee) should receive a fee as a provider of services or should be entitled to a portion of any additional return attributable to the marketing intangibles. The Guidelines direct that the rights and the obligations of both the owner of the trademark and the marketer should be considered. 56 The implicit position of the OECD Guidelines is precisely that, under arm s-length conditions, a licensor will not be prepared to grant the licensee (co-)ownership of the trademark, to the effect that the licensee acquires a right to a share in the value development of the trademark itself on termination of the license. The unrelated licensee will, however, ensure that the conditions subject to which it undertakes promotional activities for its own account and risk are such that it can expect a reasonable return on its investments. In such a situation, the relevance of the often long-term license right for the licensee cannot be held to be equal to (co-)ownership of the trademark. The U.S. transfer pricing regulations, as a consequence of the importance of the legal ownership of the intangibles, demonstrate a clear tendency towards the acceptance of the contractual (license) 31

12 Intellectual and Intangible Properties Illustration 4 The Arm s-length Principle The arm's-length principle requires the existence of an assumed balance between the: TRANSFEROR RIGHTS OBLIGATIONS BALANCE OF RIGHTS & OBLIGATIONS TRANSFEREE The licensee will be prepared to bear substantial marketing and promotional costs (that may increase the value of the trademark) only if the agreement includes conditions such that it will be able to profit from the investments that it made, with a combination of conditions regarding the use of the trademark (exclusivity, term, amount of the royalty fee) and the purchase price of brand-named products enabling the licensee to do so. relation that is created within a group among the owners of trademarks and licensees. The underlying principle is that the legal ownership of the trademark is acknowledged as governing for tax consequences, but legal owners includes a category of licensees that have only limited rights of use to the trademark. The OECD Guidelines, issued after the Code Sec. 482 final regulations, fully acknowledge that the fiscal ownership of the trademark is with the legal owner unless, it is assumed, all of the essential rights to a trademark in a jurisdiction were transferred to the licensee. 57 The arm s-length principle requires the existence of an assumed balance between the rights and obligations of the two parties on the conclusion of the license agreement. The licensee will be prepared to bear substantial marketing and promotional costs (that may increase the value of the trademark), only if the agreement includes conditions such that it will be able to profit from the investments that it made, with a combination of conditions regarding the use of the trademark (exclusivity, term, amount of the royalty fee) and the purchase price of brand-named products enabling the licensee to do so. 58 The entire complex of the contractual conditions must be considered. First, it must be investigated whether a possibly deviating provision is compensated by another contractual provision. For example, the marketing costs that are borne by the licensee can be compensated by contractual provisions, such as a relatively low royalty. If no arm slength balance exists within the entire complex of rights and obligations, then an adjustment must be sought within the framework of the existing contractual relation, with such conditions adjusted for and established on a case-by-case basis. A trademark can have value without being known in the territory of the licensee at the time that the license is granted, and a trademark may have proven elsewhere that it fulfils a valuable communication and identification function. It is then very possible that the concept on which the trademark is based also can be successfully launched in a new market. One of the typical characteristics of MNEs is that they are able to exploit sound ideas throughout the world, irrespective of where those ideas originally were developed, although this in and of itself does not diminish the fact that whether the trademark in question has value for the market of the licensee must be established at the time that the license is granted. 59 The term of the license is important in assessing the arm s-length nature of the entire complex of contractual relations, for as the legal owner of a trademark transfers more of its rights for longer periods, the licensee s position will move gradually from that of a one-time user to that of a (beneficial) owner of the trademark. 60 Within the framework of a group, the license agreement frequently fails to address the term of the license, making necessary the term that unrelated parties would have agreed on at the conclusion of the agreement. To the licensee, an exclusive right to use the trademark is obviously very important when it seeks to achieve a reasonable return on the investments that it made in connection with the license acquired, while on the other hand, in practice, a license is very often exclusive only if and as long as the licensee can realize certain sales of the brand-named products, thus necessitating that the contractual relationship between the owner of a trademark and a related licensee will have to show a balance between the amount and the nature of the licensee s investments and the requirements set on the success of its efforts. 61 When investigating the required balance between the rights and obligations of the 32