Roger Royse summarizes the tax issues in owning, developing commercializing and disposing of IP assets

1. Tax Planning for
Technology Transactions
Roger Royse
Partner

2. IP Tax Issues
1. All Substantial Rights
2. Sale versus License
3. Sections 721 and 351
4. Section 1235 Capital Gains
5. R&D Partnerships
6. The Associated Patentees Structure
7. Foreign and Domestic IP Holding Companies
8. Self Created Intangibles
9. 482 / Cost Sharing
2

3. “All Substantial Rights”
Transfer of All Substantial Rights? Generally, no, if:
 Use of the patent limited geographically within the country of issuance
 Time period of less than the remaining life of the patent
 Limited to specific trades or industries
 Rights that are less than all the rights covered by the patent (prior transfers)
 Limit on further sublicensing
 Grant of less than all the claims or inventions covered by the patent
 Retention of a right to terminate the transfer at will or on condition subsequent
 For purposes of securing the obligations of the purchaser, can (1) retain right to
use the invention in the event of default and (2) hold the legal title to the patent
3
Inventor
Company
Buyer
Company

4. Sale vs. License
Sale:
 Must transfer “All Substantial Rights” for sale treatment
 Sales are generally taxed as capital gains, if holding requirements are met, and
individual is not a professional inventor (see Section 1235 discussion)
 Sales will not result in “personal holding company income” – Rev. Rul. 75-202
 Purchaser may amortize under Section 197 if acquired as a part of a trade or
business; otherwise Sections 167 and 174 apply
License:
 Applies when transferor fails to transfer “All Substantial Rights”
 Generally taxed as ordinary income to licensor
 License fee is generally deductible by licensee
4

5. Sections 721 and 351
Non-recognition in both Sections 721 and 351
require a transfer of “property”
• IRS requires transfer of “All Substantial Rights” for the IP to be considered
“property”.
• Rev Rul 69-156 - transfer by a domestic corporation of an exclusive right to
import, make, use, sell, and sublicense a patent involving a chemical compound
to its foreign subsidiary was not a transfer of property within the meaning of §
351.
• Case law is more lenient: (1) United States v. Stafford, 727 F.2d 1043 (11th Cir.
1984) – contribution of letter of intent held to be “property” under Section 721
because parties viewed it as having value; (2) E.I. DuPont de Nemours v.
United States, 471 F.2d 1211 (Ct. Cl. 1973) – grant of non-exclusive patent
rights to wholly-owned subsidiary was “property” under Section 351.
5

6. Incorporations/Formation Issues
6
StartUp Inc.
(LLC)
Technology
Services Cash

7. Tax Issues – StartUp Inc.
 Code Section 83
 Option Grant
 Sale for Partially Recourse Note
 Stock Grant
 Code Sections 351/721
 Stock/Capital for “Property”
 License In
7

8. LLC Profits Interest
 Under Rev. Proc. 93-27, the receipt of a profits interest is generally not a
taxable event for the partner or the partnership.
 A member has a capital interest if he or she has a share of unrealized
appreciation in the partnership's assets.
 In Rev. Proc. 2001-43, the IRS stated that it would not tax the employee or
the partnership on grant of a non-vested profits interest.
8

9. Partnership Equity Transfers for Services
 Proposed Regulations published May 24, 2005
 Rev. Proc. 2001-43 and Rev. Proc. 93-27 Will Be Obsoleted
 Section 83 Applies to Profits Interest
 Section 83(b) Election Required for Unvested Profits Interest
 Partnership Deduction in Year of Employee’s Income Inclusion
 Partnership Recognizes No Income on Capital Shift
 Safe Harbor Election
 Forfeiture Allocations Required
 Effective When Finalized
9

10. Treatment of IP Costs
 IRC 162 allows a deduction for ordinary and necessary expenses
 IRC 263 requires capitalization of expenses that create or enhance a
separate and distinct intangible asset or create or enhance a future benefit
beyond the tax year (no current deduction under section 162).
 IRC 263A requires capitalization of certain costs attributable to property
produced by a taxpayer or acquired for resale in a trade or business or an
activity conducted for profit
 IRC § 174 provides a current deduction for certain types of research and
experimental (R&E) expenses – activities intended to discover information
that would eliminate uncertainty concerning the development or improvement
of a product. Under § 174, a taxpayer may elect to (1) currently deduct all
R&E expenses made in connection with the taxpayer’s trade or business, or
(2) amortize the expenditures over a period of not less than 60 months
beginning with the month in which the taxpayer first realizes benefits from the
expenditures.
 IRC § 195 allows taxpayers to elect to deduct certain expenses incurred
before the business becomes active over a 15-year period.
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11. 11
 IRC § 197 generally applies to acquired intangible assets
 Amortize § 197 intangibles ratably over a 15-year period
 An amortizable § 197 intangible is any “§ 197 intangible” held in connection with the
conduct of trade or business or the production of income and includes
• Patents;
• Copyrights;
• Formulas;
• Processes;
• Designs;
• Patterns;
• Know-how;
• Formats or other similar items; and
• Franchises, trademarks, or trade names.
 Also applies to limited class of self-created intangible assets that are not part of an
acquisition of a business, including trademarks and trade names
Section 197 – Costs

12. 12
 IRC § 167 amortization may be used if: (1) an asset has a useful life, and if so (2)
the length of the useful life.
 Patents and copyrights have a useful life that can be reasonably estimated.
 Trade secrets and know-how generally have been held to not have limited
useful lives because they remain valuable as long as they remain
confidential.
 Safe harbor permits a taxpayer to treat an intangible asset as having a
useful life of 15 years, unless
 (1) another useful life is specifically prescribed or prohibited under the
tax law,
 (2) the intangible asset is acquired from another person or is a financial
interest,
 (3) the intangible asset has a useful life that can be reasonably
estimated, or
 (4) the intangible asset relates to certain benefits arising from realty.
IRC section 167

13. Character of Sales Gain
13
 IRC § 1221 - a capital asset is property owned by a taxpayer, whether or not
connected with the taxpayer’s trade or business, that is not:
 Stock in trade (inventory)
 Depreciable property
 Self created IP (including patents under TCJA)
 Accounts
 Certain US Government publications
 Certain financial instruments
 Certain hedging transactions
 Supplies

14. 1231 Gain/Loss
14
 Capital Gain/Ordinary loss
 Property used in a trade or business, subject to the allowance for depreciation
under § 167 and held for more than one year
 1231 excludes
 (1) inventory,
 (2) property held for sale to customers in the ordinary course of a trade or
business, and
 (3) self-created intellectual property, including patents.

15. IRC Section 1235
15
 A transfer consisting of “all substantial rights” to a patent, or a transfer of an
undivided interest in the patent, is considered to be a sale or exchange of a capital
asset held for more than one year.
 Actual holding period is irrelevant.
 Consideration may be payable periodically with the transferee’s use of the patent
or contingent on the productivity, use, or sale of the patent.
 Holder of a patent is any individual whose efforts created the invention and any
other individual who acquired his or her interest in the property right in exchange
for consideration in money or money’s worth, provided the price is paid prior to the
actual reduction to practice of the invention.
 Acquirer cannot be the employer of the creator of the invention nor related to the
creator
 Regulations define “all substantial rights”

16. 1235 All Substantial Rights
16
Regulations - None of the following satisfy the all substantial rights test:
 A transfer that is limited geographically within a country of issuance
 A transfer that is limited in duration to a period less than the remaining life of the
patent
 A transfer that grants rights in fields of use within trades or industries that are less
than all the rights covered by the patent that exist and have value at the time of the
grant
 A transfer that grants less than all the claims or inventions covered by the patent
that exist and have value at the time of the grant
 A transfer in which the transferor retains the right to terminate the transfer at will
Treas. Reg. §1.1235-2(b)

17. Copyright
Costs
 Most copyright costs must be capitalized under section 263 or 263A (no
current deduction under section 162)
 Subject to depreciation
 195 Startup expenses
 Inventory costs
Revenues
 Capital Asset does not include copyright held by person whose personal
efforts created it or to whom it was assigned in a carryover basis transaction
 Personal efforts of corporation? (when a corporation’s asset is created by
multiple individuals, paid market wages, the asset is not created by personal
efforts and therefore qualifies as a capital asset)
 Inventory
 Software as franchise
17

18. Trademarks
Acquisition Costs
 Expenses to develop trademark must be capitalized
 No depreciable life
 Section 195 (startup costs) does not apply
 Section 197 15 year amortization
 Contingent or periodic payments deductible
Income from Disposition
 Receipt of amounts contingent on productivity, use or disposition are non-
capital
 Retention of any significant power, right or continuing interest (quality control)
results in ordinary income
18

19. Patents
 Gain on sale is not ordinary, unless 1235 applies
 1235 Capital Gains
 Available to Holders
 Inventor
 Obtained an interest in the invention before reduction to practice
 N/A Related Party Transactions
 N/A Employer of Creator
 Deduction of R&D Expenses under 174
 Section 41 Credits
 Capitalize and Amortize
19

20. Trade Secrets and Know How
 Section 1235 applies to potentially patentable trade secrets
 Treatment as Property
 Transfer of all substantial rights
 No retained rights to use
20

21. Software: Patent or Copyright
Copyright
 Not Capital Asset in hands of Creator
 One year capital gains holding period
Patent
 Sale by Holder qualifies for capital gain transaction
 1235 instant capital gains
 Recapture of depreciation
Under new §1221(a)(3) [amended by TCJA], patents, inventions, models or designs (whether or not
patented), and secret formulas and processes that are created by a taxpayer’s “personal efforts” are
treated as ordinary. Self-created software, models and “secret processes are ordinary income
assets.
21

22. Personal Holding Company Income
 Personal Holding Company
 More than 50% owned by 5 or fewer individuals
 60% of adjusted ordinary gross income is PHCI
 Personal Holding Company Income
 Includes patent royalties
 Copyright royalties are excluded from PHCI if they are more than half of
gross income and the company has little other PHCI
 Exception for active computer software royalties
 15% penalty tax for undistributed PHCI
 Subchapter S passive income for S corps with former C corporation E&P
 If PHCI exceeds 25% of gross income, corporate level tax on excess net
passive income
 S election can terminate if excess passive income for 3 consecutive
years
22

23. Busted 351
 OldCo wants Inventor’s patent for restricted stock
 Inventor wants OldCo Stock
 Can’t do a 351 because of 80% requirement
 Rev. Ruling 70-140; Weikel v CIR, 51 TCM 432 (1986)
 Substantial business purpose
OldCo, Inc.
Shareholders Inventor
Patent
23

24. Tax Free Reorganization
StartUp LLC
Incorporated
Acquiring Corporation
Merger
24

25. Tax Issues – StartUp Inc.
OldCo Inc. NewCo Inc.
Merger
Shareholders
Inventor
Patent
Stock
Step Transaction – sale
Continuity of business
25

26. TCJA and GILTI
26

27. Contract Manufacturer Structure
Tax Haven Company
(PRC)
Manufacturer
Founder
U.S. Co
Ashland Oil v. CIR
Vetco Inc. v. CIR
Rev. Rul. 97-48
Contract Manufacturer is not a branch
Are activities of contract manufacturer
attributed to tax haven company?
Contract
manufacturing
Technology ownership
Contract R&D
service fees
100%
Service fees
Preferred
shareholder
Optionees
U.S. Sales
Products
Local
Distributors
Cash or property
Ownership
27

28. International E-Commerce Operations
Server Company
Local Country
Company
License/Royalty
International
Holding
Company
U.S. Company
Customer
fees/sales
Royalties
Cost sharing
License
Deemed sale
Commission/Fees
28

29. IP Holding Company Structures
Foreign Company
Holds IP
Tax Haven
Company w/
Technology
(PRC)
Manufacturer
Founder
U.S. Co
Contract
manufacturing
Contract R&D
service fees
100%
Service fees
Preferred
shareholder
Optionees
U.S. Sales
Products
Local
Distributors
29

30. IP Holding Company Structures
Domestic Company
Holds IP
Tax Haven
(HK Office)
(PRC)
Manufacturer
U.S. Company
with
Technology
100%
U.S. Sales
Local
sales Local
Distributors 100%
30

31. Current International Tax Rules
 Section 245A: Participation Exemption
 Section 951A: Global intangible low-taxed income (“GILTI”)
 Section 250: Foreign-derived intangible income (“FDII”)
 Subpart F
 Passive Foreign Investment Companies (PFIC)
 Transfer Pricing Rules
 Tax exempt organizations vs associations
31

32. Section 245A – “Participation Exemption”
 Deduction for certain foreign source dividends from 10% owned foreign
corporation paid to domestic corporation
 Modified territoriality
32

33. Global Intangible Low-Taxed Income (GILTI)
 50% corporate deduction for GILTI. At 21% rate, that means 10.5%, until 2025
 Based on net income less deemed return on tangible assets (10% of QBAI)
 GILTI high tax exception if the CFC’s effective foreign rate on GILTI gross
tested income exceeds 18.9% (i.e., more than 90% of the U.S. corporate
income tax rate of 21%) and the U.S. shareholder elects to exclude
 Taxed at ordinary rates (with no indirect credits for individuals)
33

34. Foreign-Derived Intangible Income (FDII)
 C corporations
 Foreign net income in excess of deemed return on tangible assets
 37.5% deduction
 Effective tax rate of 13.125% (until 2025)
34

35. Subpart F
Certain types of mobile income (SPF income) of controlled foreign corporations
(more than 50% owned by U.S. shareholders) taxable as deemed dividends to
U.S. shareholders (10% owners)
35

36. Subpart F
 U.S. shareholder of CFC is taxed directly on pro rata share of CFC's Subpart
F income.
 Foreign corporation is CFC if more than 50% of its stock, by vote or value, is
held by U.S. shareholders at any time during the year.
36

37. Subpart F - Example
Subpart F income includes
royalties, except royalties
derived in the active conduct
of a trade or business if
received from a person who
is not a related person.
U.S. Co
Base
Company
Tax Haven
Company
Cash or Property
Ownership
100%
Technology
Ownership
100%
Royalty
License
Manufacturing and Sales
37

38. Foreign Base Company Sales Income
 Subpart F income
includes Income from
sales of goods when CFC
purchases goods and
either sells them to, or
buys them from, a related
party
 Same country exception
U.S. Co
Base
Company
Tax Haven
Company
Cash or Property
Ownership
100%
Sales
100%
Sales
Manufacturing
38

39. Branch Rule
 Subpart F Income includes sales
income if a related person is the
seller or buyer
 Exception for income from sales
of goods manufactured or
produced by the CFC
 Manufacturing branches treated
as separate corporations if
located outside the country of
incorporation, and the effective
rate of tax on non-branch income
is less than the lesser of (i) 90%
of rate of country of
manufacturing, or (ii) a rate 5
percentage points below country
of manufacture rate.
U.S. Co
Tax Haven
Company
Sales branch
100%
Manufacturing branch
39

40. PFIC
U.S. persons owning shares of a passive foreign investment company (PFIC)
have either (i) current taxation on the income of the PFIC (under a QEF election)
or (ii) a deemed tax and interest regime.
40

41. Transfer Pricing
Code Sec 482 requires transactions between related parties to be at arm’s length
41

42. Transfer Pricing
 Under Code section 482, the IRS can re-allocate income among "controlled"
entities to properly reflect income.
 The prices charged between related parties (“transfer prices”) are required to
be arm's length prices.
 Substantial penalties for understatements of US tax due to transfer pricing
adjustments – 20% or 40% of the underpaid taxes, depending on the size of
the understatement.
 Penalty may be avoided if taxpayer has adequate documentation supporting
its transfer prices (i.e. a transfer price study)
42

43. Cost Sharing
 Split ownership of Intangibles
 Share costs and exploitation rights
 No Intercompany Royalty
 Can migrate intangibles to low tax
country
U.S. Co
Foreign
Operations
Company
Ownership
of intangibles
Capital
Technology
Distribution Network
Buy in
payment
Current Problems:
Nonexclusive
Technology reverts on termination
43

44. Withholding
 30% on US Source royalties paid to foreigner
 Lower Treaty Rates
 Characterization of payment as royalty, service fee or product
 1.861-18 Regulations relating to computer programs as sales, licenses,
leases, services, or know-how
44

45. Effectively Connected Income
 Section 351 does not apply to
transfers of Intangible Property to
foreign corporation
 Transfer of IP treated as sale for
contingent payments
 Commensurate with income from
the IP
U.S.
Parent
IP
Holding Co.
Stock
IP transfer
45

46. 367(d) Super-Royalty
 Foreign corporations are taxable on
income that is effectively connected with
a US trade or business
 Income attributable to a US office or
other fixed place of business
 A U.S. trade or business can be carried
on through an agent
 A foreign corporation's "independent"
agent will not constitute a US office but a
dependent agent might.
 The office of a dependent agent is
disregarded unless the agent has and
regularly exercises the authority to
conclude contracts in the name of the
foreign company or has a stock of goods
belonging to the foreign company from
which orders are regularly filled on
behalf of the foreign company.
Foreign
Corporation
U.S. PE
46

47. Passive Foreign Investment Companies (PFIC)
 Income Test: 75% of gross income is passive
 Asset Test: 50% of assets produce passive income
 Interest charge on "excess distributions" from PFICs
 QEF Election
47

48. Sales Tax
 R&D Contracts nontaxable under true object of the contract test
 Navistar v. SBE – sale of drawings and manuals were taxable
 Transfer via Remote Telecommunication
 Custom made software: Cal. Code Regs tit. 18 Section 1502(f)(2) - Sales of
custom software programs are not taxable no matter how they are delivered,
even if the sale or lease of computer equipment is a part of the sale
 Publishers Exemption: Cal. Code Regs tit. 18 Section 1502(f)(1)(B) - Tax does
not apply to license fees or royalty payments for right to copy a program to
which a federal copyright attaches in order for the program to be published
and distributed for a consideration to third parties, even if a tangible copy of
the program is transferred concurrently with the granting of such right
 Cal. Code Regs tit. 18 Section 1502(f)(1)(D) sale of canned software on a disc
or other tangible medium is taxable, but sale via download is not taxable
48

49. Effectively Connected Income
Employees
Admin, legal and commercial
Registrations, enforcement
R&D, commercialization
California
Parent
Nevada IP
Holding Co.
License
back
IP transfer
Services income
49

50. Capital Gain Under Section 1235
Allows patent “holder” to obtain long-term capital gains treatment regardless of
holding period, the method of payment, and the status of the inventor as a
professional; could potentially apply to trade secrets or other patentable know-
how
Requirements
 Available to “holders” – meaning either the individual who (1) created the
patent or (2) acquired an interest therein prior to reduction to practice; look-
through for LLC ownership
 Must transfer “all substantial rights”
 “Patent” means a patent granted under domestic law, or any foreign patent
granting rights generally similar to those under a United States patent; not
necessary that patent or application be filed
 Not available in (1) transfers to “related parties” (25% threshold) or (2) “hired
to invent” scenarios
50

51. R&D Partnerships
 LDL Research & Development II, Ltd.
 Partnership had no real prospect of exploiting technology
 Developer relied on to conduct technology business
 Only possibility that partnership would ever act
 Kantor v. CIR
 Partnership must have realistic possibility of entering its own business
 Prospect of entering business must be shown at time of expenditure
 Option to acquire exclusive rights for nominal sum
 Lack of Capability to enter business
 Scoggins v. CIR
 Developer had significant cost option to acquire IP
 Partnership was capable of developing business if developer did not
51

52. R&D Partnerships
Scoggins Partnership
 Tax Advantaged Structure
 R&D Deductions
 Former Capital Gain Treatment (OI Under
TCJA)
 Bankruptcy Remote Partnership
 Liability Protection
Partnership
or LLC
Investors Inventor
Option to Buy
Non-Exclusive
License Operating
Corporation
Shareholders
52

53. Associated Patentees Character Converter
Associated Patentees, Inc.: current deduction for payments
based on patent’s use or production
R&D
Partnership
Contingent
Payments
“Sale” of Patent
Developer
Corporation
53

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