tax aspects of technology...
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TAX ASPECTS OF TECHNOLOGY TRANSACTIONS
Roger RoyseRoyse Law Firm, PC
2600 El Camino Real, Suite 110
Palo Alto, CA [email protected]
www.rroyselaw.comwww.rogerroyse.comSkype: roger.royse
IRS Circular 230 Disclosure: To ensure compliance with the requirements imposed by the IRS, we inform you that any tax advice contained in this communication, including any attachment to this communication, is not intended or written to be used, and cannot be used, by any taxpayer for the purpose of (1) avoiding penalties under the Internal Revenue Code or (2) promoting, marketing or recommending to any other person any transaction or matter addressed herein.
BAYTLFebruary 2,
2011
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TAX OBJECTIVES
Exploit Rate Differentials
Defer, Defer, Defer (Then Die)
Avoidance (Exemption or Non recognition)
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OVERVIEW
1. Technology Transfers
2. Entity Formation
2. R&D Partnerships
3. IP Holding Companies
4. Foreign Structures
5. Litigation Recoveries
6. New Developments
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SALE vs. LICENSE(15% vs. 35%)
Sale:• “All Substantial Rights”
• Capital gains
• No “Personal holding company income”
• Section 197 Amortization
License:• No transfer of “All Substantial Rights”
• Ordinary income
• Ordinary deduction
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INCORPORATION / FORMATION ISSUES
StartUpCompany
Technology
Services
Cash
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SECTIONS 721 AND 35115% or 35% vs. 0%
Non-recognition requires a transfer of “property”
• IRS requires transfer of “All Substantial Rights”
• Case law is more lenient:
• United States v. Stafford, 727 F.2d 1043 (11th Cir. 1984) – contribution of letter of intent held to be “property”
• E.I. DuPont de Nemours v. United States, 471 F.2d 1211 (Ct. Cl. 1973) – grant of non-exclusive patent rights
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“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
Inventor Company
Buyer Company
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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
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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
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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.
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PARTNERSHIP EQUITY TRANSFERS FOR SERVICES
Proposed Regulations published May 24, 2005Rev. Proc. 2001-43 and Rev. Proc. 93-27 Will Be ObsoletedSection 83 Applies to Profits InterestSection 83(b) Election Required for Unvested Profits InterestPartnership Deduction in Year of Employee’s Income InclusionPartnership Recognizes No Income on Capital ShiftSafe Harbor ElectionForfeiture Allocations RequiredEffective When Finalized
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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
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COPYRIGHT
• Costs– Most copyright costs must
be capitalized (no current deduction)
– Subject to depreciation– 195 Startup expenses– Inventory costs– Software may be
depreciated over 36 months
• 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?
– Inventory– Software as franchise
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PATENTS
• Deduction of R&D Expenses under 174
• Section 41 Credits
• Capitalize and Amortize
• 1235 Capital Gains– Available to Holders
• Inventor• Obtained an interest
in the invention before reduction to practice
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TRADE SECRETS AND KNOW HOW
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• Section 1235 applies to potentially patentable trade secrets
• Treatment as Property
• Transfer of all substantial rights– No retained rights to use
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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
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SOFTWARE
• Right to copy
• Transfer other than right to copy
• Produced for purchaser
• Transfer of copyright right – sale or royalty
• Sale or rent
• Services
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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
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BUSTED 351
Shareholders Inventor
Patent
OldCo wants Inventor’s patent for restricted stockInventor wants OldCo StockCan’t do a 351 because of 80% requirement
OldCo, Inc.
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TAX FREE REORGANIZATION
MergerStartUpLLC
INCORPORATED
AcquiringCorporation
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TAX ISSUES – STARTUP, INC.
Shareholders Inventor
PatentStock
Merger
OldCoStock
Step Transaction - saleContinuity of Business
OldCo, Inc.
NewCo, Inc.
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WITHHOLDING
• 30% on US Source royalties
• Lower Treaty Rates
• Characterization of payment
• Fees or Royalty
• 1.861-18 Software Regulations
1.861-18 Regulations
• Computer programs
• Sales
• Licenses
• Leases
• Services
• Know-how
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367(d) SUPER-ROYALTY
• 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
IP Transfer Stock
US Parent
IPHolding Co.
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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)
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COST SHARING
Buy InPayment
OwnershipOf Intangibles
Split ownership ofIntangibles
Share costs and exploitation rights
No Intercompany Royalty
Can migrate intangibles to Low tax country
Current Problems:
NonexclusiveTechnology reverts on termination Capital
TechnologyDistribution Network
Foreign OperationsCompany
USCompany
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EFFECTIVELY CONNECTED INCOME
• 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 dependant agent might.
• The office of a dependant 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.
US PE
ForeignCorporation
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SUBPART F
• US 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.
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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
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SUBPART F - EXAMPLE
US Co
Base Company
Cash or PropertyOwnership
100%
TechnologyOwnership
TaxHavenCompany
100%
Royalty
License
Manufacturing and Sales
• 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.
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FOREIGN BASE COMPANY SALES INCOME
US Co
Base Company
Cash or PropertyOwnership
100%
TaxHavenCompany
100%
Sales
ManufacturingSales
• 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
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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.
US Co
100%
TaxHavenCompany
Manufacturing Branch
Sales Branch
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CONTRACT MANUFACTURER STRUCTURE
US Co
ContractManufacturing
[PRC]ManufacturerLocal
Distributors
Products
US Sales
Service Fees
Cash or PropertyOwnership
100%Contract R&DService Fees
FounderPreferredShareholder
Optionees
TechnologyOwnership
TaxHavenCompany
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?
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INTERNATIONAL E-COMMERCE OPERATIONS
USCompany
InternationalHoldingCompany
ServerCompany
LocalCountryCompany
License/Royalty
Commission/Fees
CustomerFees/SalesRoyalties
CostSharing
License
DeemedSale
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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: Reg. 1502(f)(2)
• Publishers Exemption: Reg. 1502(f)(1)(B)
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STATE TAX ISSUES
CaliforniaParent
Nevada IPHolding Co.
IP Transfer LicenseBack
Services Income
EmployeesAdmin, legal and commercialRegistrations, enforcementR&D, commercialization
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ASSOCIATED PATENTEES CHARACTER CONVERTER
R&D Partnershi
p
“Sale” of Patent
Contingent Payments
Developer Corporatio
n
Associated Patentees, Inc.: current deduction for payments based on patent’s use or production
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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
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R&D PARTNERSHIPSSCOGGINS
PARTNERSHIP
Partnership
or LLC
Investors Inventor
Option to Buy
Non-Exclusive License
Shareholders
Operating Corporatio
n
• Tax Advantaged Structure • R&D Deductions• Capital Gain Treatment
• Bankruptcy Remote Partnership• Liability Protection
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IP HOLDING COMPANY STRUCTURES
OptioneesFounder
PreferredShareholder
FOREIGN COMPANY HOLDS IP
US Sales US Compan
y
100% Contract R&DService Fees
LocalDistributors Products
Tax HavenCompany
w/ Technology
Service Fees
ContractManufacturing
[PRC]Manufacturer
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IP HOLDING COMPANY STRUCTURES
US Sales
US Company
Contract R&DProduct sales
Tax Haven
Technology License
100%
Products
Service Fees
ContractManufacturing(or License)
Manufacturer
100%Local
Distributors
Local Sales
DOMESTIC COMPANY HOLDS IP
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Litigation Recoveries
Payor – deduction vs. capitalizedRecipient – ordinary vs. cap gains vs. capital recovery
Origin of the Claim Test
State Tax issues related to venue
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CLIENT PARTNERSHIP WITH ATTORNEY
Inventor
Attorney
Infringement Claims
Legal Services
Patent Infringement
LLC
Litigation Proceeds Defendan
t
• Generally, legal expense deduction limited by (1) 2% floor on AGI, (2) alternative minimum tax and (3) itemized deduction phase out
• Structuring the relationship as a client-attorney partnership may eliminate the client’s tax on the portion paid to the attorney; in a partnership, the client’s gross income will not include legal expenses
• Can be useful in prosecution of patent infringement claims
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CLIENT PARTNERSHIP WITH ATTORNEY
Partnership Formalities• An Agreement;• Conduct of the parties in execution of its provisions;• Statements of the parties;• Testimony of disinterested persons;• Relationship of the parties;• Respective abilities and capital contributions of the parties;• Actual control of income and purposes for which it is used; and• Other facts showing the true intent of the parties (file partnership
return).
Other Issues• Federal tax law determines existence of partnership (not State)• State rules of professional conduct (conflicts, partnership with
non-attorney)• Control of the case
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Section 409A Issue
Section 409A Issue• IP transfer distinguished from services agreement -
Boulez v. Comr., 83 T.C. 584 (1984).
• Ownership rights are essential in a transfer of IP.
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NEW DEVELOPMENTS
2010 Small Business Jobs Act• September 27, 2010, President Obama signed into
law the Small Business Jobs Act of 2010.
• The Act doubled the Section 179 immediate deduction for certain new property placed in service during 2010 and 2011.
• The Act provides for 50% bonus depreciation on new MACRS property with a recovery period of 20 years or less (and certain computer software) placed into service in 2010.
• The Act increased the capital gain exclusion to 100% on the sale of qualified small business stock acquired between Sept. 27 and the end of 2010.
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NEW DEVELOPMENTS
2010 Tax Extender Bill• December 17, 2010, President Obama signed into
law the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010
• The Act reduced the Section 179 immediate deduction for certain new property placed in service during 2012 and subsequent years.
• The Act provides for 100% bonus depreciation on new MACRS property with a recovery period of 20 years or less (and certain computer software) placed into service in the end of 2010 and through 2011, which rate goes back down to 50% for 2012.
• The Act extended the capital gain exclusion to 100% on the sale of qualified small business stock acquired during 2011.
• The Act extended the Research Credit through 2011.
• The Act extends many energy related provisions through 2011.
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NEW DEVELOPMENTS
IRS – Uncertain Tax Positions• December 17, 2010, the IRS released final
regulations (T.D. 9510) that allow the IRS to require that certain taxpayers file a schedule disclosing “uncertain tax positions” with their tax returns.
• The filing requirement will apply to taxpayers based on their asset values, as follows: 2010 – larger taxpayers (assets in excess of $100 M); 2012 – medium taxpayers (assets in excess of $50 MM); 2014 – smaller taxpayers (assets in excess of $10 MM).
• The IRS disclosure requirement is similar to the disclosure requirement under Financial Accounting Standards (FIN 48).
• Disclosures will be detailed, and will contain – (i) ranking of size of uncertain positions, (ii) the Code section(s) implicated, (iii) the years applicable, and (iv) statements about the income, gain, loss, timing, valuation, and basis relevant to the uncertain position.
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NEW DEVELOPMENTS
Codification of Economic Substance Doctrine
• Codified as a part of the Health Care and Education Reconciliation Act (P.L. 111-152), signed March 30, 2010.
• Immediately effective.
• Clarifies doctrine’s requirements that –
(1) the transaction changes in a meaningful way (apart from Federal income tax effects) the taxpayer's economic position, and
(2) the taxpayer has a substantial purpose (apart from Federal income tax effects) for entering into such transaction.
• Not meant to change circumstances in which doctrine is applied.
• 40% strict liability penalty.
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