Cross-License (March 2006).qxd

ALERT

KIRKLAND & ELLIS LLP

March 2006

United States Considering the Tax

Treatment of International Cross-Licenses

of Intellectual Property

I. INTRODUCTION

In a recent notice, Notice 2006-34 (the Notice), the United States Treasury Department

(Treasury) and the Internal Revenue Service (IRS) have requested information regarding

cross-licenses of patents and other intellectual property. Treasury and the IRS indicated that

they are considering requests for specific guidance on the tax treatment of such transactions.

Any such guidance would break new ground, and might cause cross-licensing transactions

that have historically been treated, in practice, as nontaxable to become subject to United

States tax, including, in the case of cross-border transactions, to United States withholding

tax.

Treasury and the IRS indicated that they are aware that cross-licenses may arise in a range of

commercial contexts, including circumstances in which the parties intend to exploit the cross-

licensed patents, circumstances in which the cross-license is intended to avoid the risk of

patent infringement claims and mixed circumstances of various sorts. Treasury and the IRS

also noted that they recognize the importance of the rights involved in cross-licenses and the

significance of the issues raised by these transactions, and that they intend to give the issues

raised by cross-licenses careful study so that appropriate guidance can be issued on the tax

treatment of such transactions.

II. DISCUSSION

In the Notice, Treasury and the IRS indicated that they had received requests for guidance on

the tax treatment of cross-licenses, including whether a U.S. person’s grant to a foreign person

of the right to use specified intellectual property pursuant to a cross-license gives rise to

income that may be subject to withholding tax. In response to these requests for guidance,

Treasury and the IRS are analyzing, and expect to issue guidance regarding, certain tax issues

related to cross-licenses.

A. The Uncertain Tax Character of Cross-Licenses.

Treasury and the IRS noted that the tax treatment of cross-licenses depends on the

characterization of the cross-licensing transactions for tax purposes, and further noted that

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different theories have been suggested by taxpayers and their

representatives concerning the proper characterization of

cross-licensing transactions and the associated tax

consequences. Three major theories would characterize a

cross-license as, alternatively, (1) a two-way license of

intellectual property rights; (2) a reciprocal agreement not to

assert claims of infringement; or (3) a sale or exchange of

property. Treasury and the IRS indicated that they are

considering the most appropriate characterization for cross-

licensing (e.g., in light of intellectual property law, business

realities, or the particular facts of the cross-licensing

transaction), and the income tax consequences of each

theory, including the amount, source and timing of any

income, expense, gain or loss from the transaction and the

potential withholding tax consequences if a foreign party is

involved.

1. Two-Way License.

Under this theory, a cross-licensing transaction would be

characterized as a two-way license of intellectual property

rights. The potential income tax consequences under this

theory could include:

• Gross royalty income is realized by the foreign licensee in

an amount equal to the value of the license rights and

any cash payments received.

• Income is recognized currently, except that any

contingent payments would be recognized in the period

in which they arise.

• The value of license rights conveyed and any cash

payments made may be deductible or may be subject to

capitalization.

• Withholding tax potentially applies to the conveyance of

license rights and any cash payments to a foreign party to

the cross-license, to the extent amounts are allocable to

U.S. sources.

2. Reciprocal Agreement not To Assert Claims of

Infringement.

Under this theory, a cross-license would be characterized as a

reciprocal agreement not to assert claims of infringement.

Treasury and the IRS noted that the tax consequences of this

theory are uncertain, requiring a further determination as to

whether a cross-license so characterized should be treated as a

two-way license, a sale or exchange of property or a form of

services or covenant not to compete.

The potential income tax consequences under this theory

could include:

• The amount of income realized might be limited to the

amount of any cash payments. Alternatively, the amount

of income realized might be the value of the license

rights and any cash payments received.

• Income would be sourced based on the underlying

characterization. For example, if the transaction is

analyzed like a traditional two-way license, then the

income would be sourced as a royalty. Alternatively, if the

transaction is analyzed as services, then the income

would be sourced to where the services were performed.

• Income would be recognized currently, except that any

contingent payments would be recognized in the period

they arise.

• Withholding tax consequences would be based on the

U.S. source consequences of a particular characterization.

For example, no withholding tax would apply to the

extent of services income allocable to foreign sources.

3. Sale or Exchange of Property.

Under this theory, a cross-license would be characterized as a

taxable or nontaxable sale or exchange of property. The

potential income tax consequences under this theory could

include:

• Gross income is realized in the amount of the gain or loss

on the exchange of license rights and any cash payments

under the cross-license. Nonrecognition treatment may

be available if the transaction is treated, for example, as a

like-kind exchange.

• Gain or loss generally would be sourced based on the

residence of the taxpayer, except that any contingent

payments would be treated in the same manner as

royalties for sourcing purposes.

• Any gain or loss recognized would be recognized

currently, except that any contingent payments would be

recognized in the period in which they arise.

• If the transferor is a foreign resident, withholding tax

would not apply to gains, except that contingent

payments would be sourced in the same manner as

royalties and so would potentially be subject to

withholding tax to the extent sourced in the United

States.

B. The Request for Comments, Information and Documents.

With these uncertainties in mind, Treasury and the IRS have

requested comments, information and documents (including

samples of cross-license agreements, as well as samples of

technology transfer policy documents relating to the

negotiation of cross-licenses) for consideration in providing

specific guidance regarding the appropriate tax treatment of

cross-licenses between U.S. persons and foreign persons. In

particular, Treasury and the IRS requested submissions as to,

and asked detailed questions concerning:

• The business circumstances in which cross-licensing

arises, including the distinction between cross-licenses for

use and cross-licenses for protection against infringement

claims.

• Industry, interoperability and technical standards,

including (i) in which industries and as to which product

types cross-licensing agreements are most frequently used

and (ii) the role that industry, interoperability and

technical standards play in cross-licensing arrangements.

• Whether, and the circumstances under which, parties to

a cross-license of patents typically also license additional

intellectual property rights, such as know-how,

trademarks or trade secrets, and, apart from patent cross-

licenses, whether and when other intellectual property

rights typically are cross-licensed.

• Potential distinctions between different types of cross-

licenses, including whether there is a basis in intellectual

property law for distinguishing different uses of cross-

licensing, and, in particular, whether intellectual property

law distinguishes an agreement not to assert claims of

infringement from a license of a patent, and how the IRS

in practice might tell the difference.

• How the parties to a cross-license value the licensed

rights and determine the amount of any cash payments

payable by one party to the other.

• The financial accounting treatment of cross-licensing.

• The tax consequences of cross-licenses under foreign

income tax laws.

C. Implications.

For many years, the United States tax treatment of cross-

licenses has been the subject of benign neglect by the United

States taxing authorities. In the absence of guidance,

taxpayers have treated cross-licenses as nontaxable

transactions, frequently, in our experience, without giving the

matter much thought.

The issuance of the Notice suggests that the long period of

benign neglect will end, and that, for the first time, there will

be clear rules for the tax treatment of cross-licenses. In view

of the ubiquity and economic importance of cross-licenses,

the guidance that eventually emerges likely will be an

important element of United States tax policy with respect to

intellectual property transfers and with respect to

international taxation generally, and likely also will require at

least some changes in current commercial practice with

respect to cross-licenses.

Should you have any questions about the matters addressed in this Alert, please contact the following Kirkland & Ellis author or the Kirkland & Ellis

attorney you normally contact

This publication is distributed with the understanding that the author, publisher and distributor are not rendering legal, accounting, or other professional advice or

opinions on specific facts or matters and, accordingly, assume no liability whatsoever in connection with its use. Pursuant to Rules 7.2 to 7.4 of the Illinois Rules of

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Greer Phillips

gphillips@kirkland.com

(212) 446-4955