Development, Ownership and Licensing of Intellectual and ... · Development, Ownership and Licensing of Intellectual ... Sections 861 through 865 of the Internal Revenue Code (“the

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Taxation of Corporate Transactions/February–March 2004

©2004 W.P. Elliott

William P. Elliott, CPA, ABV, CVA, LL.M., is a Domestic & International Tax Partner at Decosimo CPAs in Chattanooga.

Development, Ownership and Licensing of Intellectual and Intangible Properties—Including Trademarks, Trade Names and FranchisesBy 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.

IntroductionThe United States asserts jurisdiction over international intellectual property transfers by way of the principles for taxing jurisdiction generally known as “domiciliary jurisdic-tion” 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 confl icting 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

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residents, domestically organized corporations and partnerships, and domestic trusts and estates and accordingly taxes such per-sons 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. per-sons. 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 in-come as foreign source.2

Under Code Sec. 865, the source of income from a transfer of intellectual property is deter-mined by the characterization of the transaction as a sale for fi xed

payments, a sale for contingent payments, a sale of depreciable personal property, a nonsale li-cense or personal compensation.

I. Intellectual Property Transfers and Source of IncomeA. Source of Income Rules

The purpose of the source rules is to assert the United States’ source jurisdiction to tax income that has suffi cient 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 in-come-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 capi-tal or property is used.

These source rules, however, are extremely broad and consequently are not so practical to use in provid-ing independent characterization criteria for determining whether an international intellectual prop-erty transfer should receive sale, license, personal compensation or other tax treatment. Inevitably, one is forced to seek other guid-ance 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-per-cent gross tax on investment gains3 includes a Code Sec. 1235 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 resi-dence of the seller as its general rule,5 and Code Sec. 865(d)(1)(A) applies to sales of intellectual property for noncontingent or fi xed payments under the general residence of the seller rule.6

B. “Fixed Payment” and “Contingent” Sales

A sale for a fi xed payment is per-haps 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 con-sideration contingent on the level of exploitation or use of the prop-erty.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 trans-fer 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 anal-ogy to copyrights, trade secrets, know-how and trademarks.9

Intellectual and Intangible Properties


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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 busi-ness10 and which the Regulations thereunder exclude from coverage the income from sales of intellec-tual personal property for fi xed payments.11 This consequently renders the 30-percent gross withholding tax to fi xed payment sales of intellectual property in-applicable. Further, assuming a foreign person’s fi xed payment sale of intellectual property is not effec-tively 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 fi xed 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 un-der Code Sec. 871(b) or Code Sec. 882(a). An exception to the gen-eral residence of the seller source rule for personal property sales ex-ists 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 suffi cient 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 contin-gent payment sales of intellectual property, paid to nonresident alien individuals and foreign corpora-tions, 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 in-tellectual 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 govern-ing the 30-percent gross tax on investment gains from contingent payment sales of intellectual prop-erty contain a unique regime for basis recovery, whereby full ba-sis 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 sig-nifi cantly from the basis recovery methods that the IRS requires for contingent payments reported un-der 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 gen-eral 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 deprecia-tion 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 deprecia-tion giving rise to the gain. Thus, gains arising from depreciation that offset U.S. source income generate U.S. source gains. Cor-respondingly, 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 ana-lyzing the potential application of the Code Sec. 865(c) depreciation recapture rule to intellectual prop-erty, the extent to which different types of intellectual property are depreciable should be con-sidered. 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 de-preciable 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 ap-plication of the Code Sec. 865(c) recapture principle has no tax ef-fect. The Code exempts such sales from tax, whether U.S. source or

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foreign source, because they have an insuffi ciently 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 for-eign source income that is exempt from tax since, absent a U.S. trade or business, depreciation generat-ing gain from such sales probably will be offset by foreign source income.16

In the case of sales of intellec-tual property by foreign persons effectively connected with the conduct of a U.S. trade or busi-ness, 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 depre-ciation offsetting U.S. source business income. Finally, in the case of U.S. persons, the appli-cation of this recapture principle to sales of intellectual property creates U.S. source income that has no foreign tax credit benefi t for gains attributable to that de-preciation 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) intel-lectual property rules. Further, it determines the source to be U.S. when any income from the sale of personal property, including in-tellectual property and inventory property, is attributable to a fi xed place of business maintained in the United States,18 which “offi ce” 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 inter-national aspects, one should fi rst determine whether any of these overriding source rules apply to determine the source.

II. Transfers of Intangible Assets20 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 per-sons 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 intellec-tual property, to shift income to foreign entities that are exempt from U.S. taxation.

Code Sec. 367(d) “recharacter-izes” contributions of intellectual property by U.S. persons to the capital of foreign corporations in otherwise nonrecognition trans-actions under Code Sec. 351 or Code Sec. 361 as deemed sales, creating deemed annual royalties. Additionally, Code Sec. 482 cre-

ates so-called “super royalties” on transfers, sales or licenses of intel-lectual property between related parties and requires the allocation of such royalties to the transferor in an amount equivalent with the income attributable to such intel-lectual 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 income22 while the latter creates income determined by the place of use of such intel-lectual property under the general source rules.23

Capital contributions of intellec-tual 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 roy-alty concept24 and is applicable to contributions of “intangible property,” defi ned broadly to in-clude 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 con-tract;method, program, system, procedure, campaign, sur-vey, study, forecast, estimate, customer list or technical data; orany similar item that has sub-stantial value independent of the services of any individual



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but excludes goodwill and go-ing 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 un-der 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 cor-poration without consideration.

The “hypothetical” royalty assumes a taxable sale of the in-tellectual property to the controlled foreign corporation (CFC) in return for a contingent royalty payable an-nually 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” in-come under Code Sec. 367(d) are extremely harsh; its practical effect is to force multinational enterprises (MNEs) to license or sell their intel-lectual property, even if to related parties subject to recharacateriza-tion under Code Sec. 482, in an effort to avoid the adverse con-sequences 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

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 manufac-

turer relationships between related parties will be deemed to consti-tute 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

Code Sec. 367(d)DeemedRoyalty

Code Sec. 482DeemedRoyalty

U.S.-

SourceIncome

Source=

Place of use

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.

TRANSFERS OF INTANGIBLE ASSETS BETWEEN “ASSOCIATED

ENTERPRISES”

Illustration 1

Illustration 2 Transfers of Intangible Assets Between “Associated Enterprises”

U.S.Person

INTELLECTUALINTELLECTUALPROPERTYPROPERTY

ForeignForeignCorporationCorporation

RelatedParty

DEEMED ROYALTY

DEEMED SUPER-ROYALTY

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.

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.

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continuous “re-evaluation” of the adequacy of intellectual property royalties in related party transac-tions. 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, sub-ject to a 30-percent gross tax. For outbound international transac-tions, 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 provi-sion should be evaluated before transferring intellectual property to related foreign entities. Alter-nately, the Code Sec. 482 super royalty provision can serve to mitigate adverse tax effects by, for example, having a foreign affi liate 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 sub-sidiary transferor.

III. Transfers of U.S.-Based Intellectual Property to Related EntitiesA. Background

As discussed in the preceding sec-tion, 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 re-lated person);a contribution (e.g., a capital contribution to the related person); oran exchange for other prop-erty (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 shift-ing 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 cor-poration in the form of excessive royalties. Two primary Code sec-tions limit the shifting of income through the transfer or licensing of intangibles. Code Sec. 482 gener-ally 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 for-eign 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 de-

pends 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 on-going dominion and control over the property, the less likely the classifi cation as a sale. Of course, classifi cation 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, fi xed consider-ation. Alternately, classifi cation of the transfer as a license results in ordinary income to the transferor and precludes basis recovery on the transfer, although the license classifi cation does defer the rec-ognition 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 con-sideration paid for the property depends mainly on whether such consideration is fi xed or contin-gent. Fixed payments made by the transferee are amortizable over a 15-year period, whereas contin-gent consideration generally is deductible currently.

Congress early remedied histori-cal confusion over the transfer of certain intangible assets, namely franchises, trademarks and trade names, in enacting Code Sec. 1253 as part of the Tax Reform Act of 1969.30 As enacted, Code Sec. 1253 sets forth two rules applicable to the transferor, the fi rst 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 signifi -cant power, right or continuing interest with respect to the subject matter of the franchise, trademark or trade name.”31 Such a signifi -cant power, right or continuing



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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 fa-cilities used to promote such products or services, require the transferee to:

sell or advertise only products or services of the transferor, andbuy substantially all its supplies and equipment from the transferor, or receive payments contin-gent on the productivity, use or disposition of the subject matter of the prop-erty 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 trans-feror is deemed to have received such consideration “from the 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 fi xed 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 Tomer-lin Trust,34 the U.S. Tax Court questioned the scope of Code Sec. 1253 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 signifi cant in addressing the federal income tax treatment of franchise, trade-mark and trade name agreements, as its considerable discussion is indicative of the confusion that existed in the courts. Prior to the

enactment of Code Sec. 1253, state law was already in disar-ray as evidenced by a series of fi ve 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, fi xed and contingent con-sideration, and the transferor’s retention of rights as to quality control and other matters.

In the fi rst 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, fi nancial audit, control over transferee’s supply and ter-mination 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, pro-prietary 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 trans-feree’s product line protected the product and brand name. How-ever, 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

Illustration 3 License vs. Sale

TRANSFERORPATENT

TRANSFEREELICENSE & ROYALTY

The greater the transferor's ongoing dominion and control over the property, the less likely the classification as a sale.

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:

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the lump-sum consideration paid at closing.36 The fourth case had identical facts as, and involved the less fortunate brother of the trans-feror 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 insuffi cient to prevent sale classifi -cation.37 In the fi nal Dairy Queen case, the Eighth Circuit ruled that the transfer was a license with re-spect to all consideration.38

Thus, fi ve 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. 1253 to evalu-ate 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 in-terest 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 jurisdic-tions, and the taxpayer could not use the trademarks on any pork-and-beans products for 20 years. The transferor could disapprove any assignment of the taxpayer’s interest in the trademarks for fi ve years. The court in Stokely stated that Congress sought to enact a “simple, uniform method” for de-termining the tax treatment of the transfer of a franchise, trademark or trade name and accordingly

rules as such to cite Code Sec. 1253 and the legislative history, not prior case law, in determin-ing whether rights retained by the transferor were signifi cant.

Nabisco Brands, Inc.40 involved an agreement for the transfer of Life Savers and other trademarks. Under the agreement, the tax-payer paid a lump sum at closing and agreed to make annual pay-ments for 10 years based on a fi xed 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. 1253 to de-termine whether the transferor’s retained rights and interests in the property were signifi cant and did not apply pre-Code Sec. 1253 case law in this regard. Other courts have read Code Sec. 1253 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. 1253 to be the defi nitive test of sale versus license classifi cation. In Consolidated Foods,42 the Seventh Circuit stated that Con-gress enacted Code Sec. 1253 to provide uniform treatment of the issue.

Although regulatory pronounce-ments 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. 1253 case law.43

Thus, based on the legislative history, case law and administra-tive pronouncements, it would

seem prudent reasoning to view Code Sec. 1253 as the sole author-ity 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 signifi cant 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 “Signifi cant Rights”

Where the transferor retains a signifi cant right, the transaction generally is treated as a license and not as a sale of an ordinary-income asset. The transferor’s tax treatment on the grant of a fran-chise, trademark or trade name depends on the extent of the rights it retains in the underlying proper-ty, 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 signifi cant right, the transfer should be a sale, with the transferor computing gain or loss under Code Sec. 1001. The fi xed or contingent nature of the consideration could be a distin-guishing 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 transfer-ors have no adjusted basis for tax purposes in the transferred prop-erty either because the property is self-developed or because the transferor succeeded to its prop-



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erty rights by way of a license in the fi rst 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 includ-able in the transferor’s amount realized for purposes of install-ment method calculations, which defers the transferor’s recovery of its tax basis in the property, per-haps 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 classifi cation but rather on the fi xed or contingent nature of its payments. Contingent consider-ation45 typically is deductible in full, while lump sum and other, fi xed 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 specifi cally 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 suffi cient to trigger license treatment, as no equitable, de minimus-type exception should prevent a trans-action from being a license simply because the transferor retains only one signifi cant 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 signifi cant re-tained 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 contin-gent payments will be substantial relative to total consideration.

IV. MNEs47 and the Development, Ownership and Licensing of Trademarks and Trade NamesA. 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 fi nancially: They ap-pear to be the preeminent owners of distinctive intangibles, particu-larly strong brand names, with the rapidly increasing signifi cance of trademarks and other intangibles giving rise to the necessity or de-sirability 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 ex-ploit trademarks in a regional or global context and can introduce a successful trademark that was developed locally in other mar-kets. In various countries, the financial significance of trade-marks to trade and industry, and in particular the above-described tendency towards the develop-ment and use of trademarks on a regional or even global scale, has led to detailed tax rules, includ-ing 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 in-tangibles,” often created through costly and risky technological re-search 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

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may use to identify special products or services of a par-ticular 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 mo-nopoly in certain products or services whereas trademarks alone do not, because com-petitors 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 specifi c 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 benefi t 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 prod-ucts 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 man-ner of profi t allocation within the group A fast-growing, in-between category is one in which the group name is used besides the specifi c service or product trademark not only with the specific product mark, but also to feature promi-nently the group name, perhaps as a “seal of guarantee for qual-ity.” The responsibility thus taken by the group for the quality of its brand-named products is ex-tremely important to the group company/licensee concerned about the positioning of the prod-ucts in relation to other products, with the group name being used as a general trademark name besides the trademark name attached to the specifi c product.

As with all intellectual property rights, the object of ownership (the trademark) is a creation of the law of the state concerned, which cre-ates an exclusive position for the qualifying applicant through regis-tration of the trademark, meaning that use and exploitation of the idea or concept is granted to it ex-clusively. Without the recognition, and more importantly the statu-tory 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 trade-

mark, 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 le-gal 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 operat-ing business whose products or services were protected by the trademark.50 In some jurisdictions, major trademark law impediments may interfere with the centraliza-tion 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 “benefi cial owner” (or “tax owner”) of a trademark in a cer-tain jurisdiction. The content, and in particular the meaning, of the concept varies with each jurisdic-tion, and to this end, the licensee must acquire the exclusive right to use a trademark in a jurisdiction during a period that (almost) coin-cides with the expected economic life of the trademark. The form of the fee is not necessarily decisive as a fi xed sum that is periodically due, for the term of the license need not interfere with the transfer of the benefi cial ownership. On the other hand, a once-only fee for a short-term license will fail to effect the transfer of benefi cial



31

ownership. Benefi cial ownership is involved if the licensee has ac-quired virtually all of the rights to a trademark, and the legal own-ership remains with the licensor only to secure the one-time or fi xed periodic fee (purchase price) payable by the licensee. The reten-tion of legal ownership that does not serve as security for the ven-dor, but enables him, for example, to infl uence the licensee’s behav-ior, often will not result in the licensee’s benefi cial 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 benefi cial ownership of the trade-mark, and this does not affect the possibility that the acquired rights must be regarded as a capital as-set 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 cer-tain acts with regard to a certain trademark and generally fall into the categories of (1) an exploita-tion license and franchising, (2) a usage license or (3) a distribu-tion license. If the owner of the trademark is also the seller of the products (the usage and distribu-tion 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 profi t 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 manufactur-ing of the goods and fulfi lls its role only when the fi nished goods are marketed, and, generally speak-ing, 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 fi nal regulations adopt-ing a modifi ed approach to the identifi cation 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 con-sidered 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 develop-ment of the trademark to the legal owner, apply a special defi nition of “legal ownership,” as the legal owner of a right to exploit an intangible ordinarily will be con-sidered 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 regula-tions’ most important conclusion is that not even the acquisition of a substantial part of the relevant rights makes the licensee the own-

er 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 specifi cally 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 licen-sor 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 termina-tion 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 reason-able 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 regu-lations, as a consequence of the importance of the legal ownership of the intangibles, demonstrate a clear tendency towards the accep-tance of the contractual (license)

32

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 fi nal regulations, fully acknowledge that the fi scal ownership of the trademark is with the legal owner unless, it is as-sumed, 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 as-sumed 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 re-

garding 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 con-ditions must be considered. First, it must be investigated whether a possibly deviating provision is compensated by another contrac-tual 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’s-length balance exists within the entire complex of rights and obli-gations, 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 terri-tory of the licensee at the time that the license is granted, and a trade-mark may have proven elsewhere that it fulfi ls a valuable communi-cation and identifi cation 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 ex-ploit 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 val-ue for the market of the licensee must be established at the time that the license is granted.59

The term of the license is impor-tant in assessing the arm’s-length nature of the entire complex of contractual relations, for as the legal owner of a trademark trans-fers 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 (ben-efi cial) owner of the trademark.60 Within the framework of a group, the license agreement frequently fails to address the term of the li-cense, making necessary the term that unrelated parties would have agreed on at the conclusion of the agreement. To the licensee, an ex-clusive 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 be-tween 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 investigat-ing the required balance between the rights and obligations of the

Illustration 4 The Arm’s-Length Principle

TRANSFEROR TRANSFEREEBALANCE OF RIGHTS

& OBLIGATIONS

OBLIGATIONS

RIGHTS

The arm's-length principle requires the existence of an assumed balance between the:

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.



33

owner of the trademark and the licensee, all aspects of the costs of promotion and marketing must be considered.62

The amount and form of the royalty fee is also relevant to the required balance between the rights and obligations of the two parties to a license agreement, and there exists a wide range of fee levels, depending on the (as-sumed) value of the trademark and other conditions of the license. A royalty can have many forms, the most frequent of which is the periodic royalty, based on the sales of the brand-named products (net invoice value). Ad-ditionally, there are once-only or periodic payments of a fi xed sum. A licensee that acquires an exclusive license for an indefi nite period for a fi xed annual royalty that can be terminated only by the licensee is very close to the status of fi scal or “benefi cial” owner of the trademark. In an intermediate model, a fi xed percentage of the sales is stipulated for a similar, “perpetual” license, and the par-ties can agree on such a fee if a trademark that has become known for a certain group of products is further developed by the licensee, through substantial investments, for another group of products. The fi xed fee represents the value of the trademark for the other prod-uct category at the time that the license was initially granted.63

D. Cost-Sharing Arrangements (CCAs) for MNEs

Within a multinational enterprise, costs in relation to services that are rendered within the group, or in relation to products and ser-vices that the group developed for the market, are increasingly borne jointly by the relevant group companies, with the anticipated

or relative benefi ts that each of the companies can reasonably derive serving as the key to allocating the overall cost burden.64 Thus, the progressive evolvement and importance of cost-contribution arrangements (CCAs) to manage and quantify these relative or anticipated benefi ts has evoked detailed regulations thereon, published in the United States as well as the more recent OECD Guidelines of 1996,65 both of which containing provisions on the ownership of intangible prop-erty, as further developed based on such CCAs.66

The assumed framework for the CCA is an agreement upon among business enterprises to share the costs and risks of de-veloping, producing or obtaining assets, services or rights, and to determine the nature and extent of the interest of each partici-pant in those assets, services or rights.67 Further, “in a CCA, each participant’s proportionate share of the overall contributions to the arrangement will be consistent with the participant’s proportion-ate share of the overall expected benefi ts to be received under the arrangement bearing in mind that transfer pricing is not an exact sci-ence.”68 The OECD Guidelines further state:

[E]ach participant in a CCA would be entitled to exploit its interest in the CCA separately as an effective owner thereof and not as a licensee, and so without paying a royalty or other consideration to any party for that interest.69

The view that the CCA par-ticipant must become at least the “benefi cial owner” of its in-terest and further would not be

required to pay any royalty is re-peated several times in the OECD Guidelines.70 This makes it evident that the participant must become at least the “benefi cial owner” of its interest, which at the start of the arrangement is equal to “the participant’s share of the overall expected benefits” and cannot be required to pay a royalty for its use. The arm’s-length principle, however, does not require that it acquire the benefi cial co-owner-ship of the brand itself. Merely because the licensees enter into a CCA (which may contribute to a positive development of the value of the brand for which the license was granted) does not in itself result in the licensees be-coming the benefi cial co-owners for their territories of the brand. It also is possible to develop an entirely new brand under a CCA based on assumptions and con-ditions that lead to co-ownership of the developed brand for every participant.

Unaffi liated parties will rarely, if ever, agree that the licensor will owe an amount for goodwill at the end of the term of a license, and that fact should be the result for the tax treatment of licenses that are granted in a group context. To-ward the end of the license term, however, its contribution to the company’s “goodwill” has dissipat-ed, and the licensure has lapsed, which does not result in an obliga-tion on the part of the trademark owner/licensor to make payments for the transfer of any “profi t po-tential” or “goodwill.” The licensee is not entitled to “goodwill” com-pensation at the end of the term of the license based solely on that circumstance, though it is possible that the licensor/trademark owner is capable of acquiring the own-ership of marketing intangibles

34

that signifi cantly contributed to the goodwill of the licensee.71 Similarly, a licensor might owe damages if the notice period (determined at arm’s length) is not observed, which must be con-sidered by using the arm’s-length principle as applied in the relevant jurisdiction.

V. Forms of Offshore Transfer of Developed Intangibles by U.S. Persons—Coordination with Code Nonrecognition ProvisionsA. Statutory and Regulatory Background

To the extent that the intangible owner is a U.S. person and the

U.S. intangible owner licenses or transfers an intangible to another affi liate or otherwise gives another affi liate the use of the intangible, the licensee/transferee generally must compensate the U.S. intan-gible owner, depending upon the nature of the transfer. U.S. transfer pricing rules govern the amount of compensation that is appropriate. In this context, the term “transfer” embodies all forms of a license, sale or exchange of an intellectual property right and can be effectu-ated in a number of ways:

A license for a lump sum and/or a periodic royaltyA sale for lump sum and/or contingent consideration other than stockA cross-license for the use of transferee intangiblesA transfer for no consider-ation by way of a capital contribution to a subsidiary or a distribution to a parent corporationA transfer in exchange for stock in the transferee

U.S. tax law technically does not preclude any kind of transfer by a U.S. person to a related foreign person that could occur between unrelated parties, but the U.S. tax consequences of the various forms of transfer may differ materially in terms of whether the transferor recognizes no income as a result of the transfer of the intangible, full gain on the transferred in-tangible at the time of transfer or periodic royalty amounts over the life of the intangible.72

The Code Sec. 482 transfer pric-ing rules generally do not govern whether a transfer is taxable, but instead govern the amount of con-sideration that must be received in a taxable transfer. Absent com-parable uncontrolled transactions that demonstrate that the amount of consideration is arm’s length, Code Sec. 482 may affect the amount of consideration received or imputed in a transfer of intan-gibles in two respects: The actual or imputed consideration received under the various types of trans-fers may be required to be roughly equivalent as an economic matter. Under the “commensurate-with-income” standard under Code Sec. 482, which was adopted by the Tax Reform Act of 1986,

the amount of consideration may have to be periodically adjusted to refl ect the value of the intangible as demonstrated, in hindsight, by the income actually derived from the intangible.73

To the extent that intellectual property rights are “bundled” with services or tangible property (e.g., hardware), the tax law does not necessarily require the trans-action to be bifurcated such that the transfer of intellectual property rights is separated from the trans-fer of hardware or the provision of services.74 A transfer of property

Illustration 5 Forms of Offshore Transfer of Developed Intangibles by U.S. Persons

INTANGIBLESU.S.

PERSON

FOREIGNPERSON

CODE SEC. 482 PRINCIPLES=

COMMENSURATE WITH INCOME

The Code Sec. 482 transfer pricing rules generally do not govern whether a transfer is taxable, but instead govern the amount of consideration that must be received in a taxable transfer.

Absent comparable uncontrolled transactions that demonstrate that the amount of consideration is arm's length, Code Sec. 482 may affect the amount of consideration received or imputed in a transfer of intangibles in two respects: The actual or imputed consideration received under the various types of transfers may be required to be roughly equivalent as an economic matter.

Under the “commensurate-with-income” standard under Code Sec. 482, which was adopted by the Tax Reform Act of 1986, the amount of consideration may have to be periodically adjusted to reflect the value of the intangible as demonstrated, in hindsight, by the income actually derived from the intangible.



35

that includes the provision of ser-vices will be treated as a transfer of property if any services are merely ancillary and subsidiary to the property transfer—i.e., the transaction, instead, must be characterized in accordance with the predominant aspect of the transaction and further require a reasonable allocation of con-sideration, if the services are not merely ancillary and subsidiary to the property transfer. There are statutory solutions, or at least safe harbors, for characterizing certain transfers of intellectual property (e.g., Code Sec. 1235 relating to patents and Code Sec. 1253 relating to trademarks and trade-names), although transfers not within the scope of those statutory provisions must be characterized under common law.

The IRS’s rulings under Code Sec. 351 establish the IRS’s admin-istrative position in distinguishing sales from licenses of intellectual property, and the IRS’s histori-cal position is that a transaction cannot qualify as a Code Sec. 351 tax-free exchange unless the transfer would constitute a sale or exchange or property rather than a license absent the application of a nonrecognition provision.75 Although there is no generally applicable Code section that determines when a transfer of know-how is a sale and not a license, the IRS has adopted guidelines similar to the rules of Code Sec. 1235 requir-ing a transfer of “all substantial rights” by ruling that a transfer of intellectual property is a sale for federal income tax purposes “where all substantial rights” to the property have been transferred to another. Finally, the ruling pro-vides that an unqualifi ed transfer in perpetuity of the exclusive right

to use the formula, including the right to use and sell the products made from and representing the formula, within all the territory of the country, will be treated as the transfer of all substantial rights in the property of that country.76 IRS has further defi ned the meaning of “perpetuity” to mean the remain-ing statutory length of a patent in the case of a transfer of a patent or, in the case of a trade secret, until it becomes general knowl-edge and is no longer subject to substantial legal protection in the jurisdiction.77

Consistent generally with IRS rulings, under the case law, a transfer of a patent generally is treated as a sale if it is a grant of an exclusive right to make, use and sell patented articles for the patent’s entire term in a country or a limited area thereof, as well as a grant of the right to prevent unauthorized disclosure of the know-how, although sale treat-ment has been denied for transfers of exclusive licenses for less than the full term of the patent. In ad-dition, nonexclusive licensing should not be treated as sales.

B. Code Sec. 1253 and Trademark Transfers

Code Sec. 1253 was intended to clarify the treatment of transfers of trademarks, trade names and franchise rights that fall within the terms of Code Sec. 1253. While Code Sec. 1235 provides that certain transfers (of patent rights) are to be treated as exchanges, Code Sec. 1253 provides that certain transfers of trademarks, trade names and franchise rights will not be treated as sales or ex-changes if the transferor retains any significant power, right or continuing interest in the subject matter of the trademark or trade

name. Such retained signifi cant power or right that will result in license treatment (and ordinary income as opposed to long-term capital gain) includes:

the right to disapprove of any assignment of the trademark;the right to terminate the ar-rangement at will;the right to prescribe the stan-dards of quality of products used or sold or of services furnished, and the equipment and facilities used to promote such products or services;the right to require that the transferee sell or advertise only products or services of the transferor;the right to require that the transferee purchase substan-tially all of his supplies and equipment from the transferor; andthe right to payments contin-gent on the productivity, use or disposition of the matter transferred, if such payments constitute a substantial ele-ment under the transfer.78

Code Sec. 1031 generally ap-plies to a transfer of intangible property (as well as exchanges of real property and tangible personal property) that is held for productive use in a trade or busi-ness or for investment in exchange for property of “like kind” that is also held for productive use in a trade or business or for invest-ment. The regulations provide less guidance for the treatment of exchanges of intangible property than for tangible personal prop-erty and real property, stating that intangible personal property is of “like kind” to other intangible per-sonal property depending on (1) the nature or character of the rights involved and (2) the nature of the underlying property to which the

36

intangible relates.79 The regula-tions otherwise do not provide any guidance relating to intan-gible property. Specifi cally, the regulations do not provide classes for intangible property because of the variety of such property and the lack of any generally available classification system. Although the IRS has issued a few private rulings on like-kind exchanges of certain intangibles, they give little additional guidance as to the scope of Code Sec. 1031, forcing taxpayers to rely generally on the common law defi nition of “like-kind property.” The qualifi cation of a cross-license as a like-kind exchange does not necessarily mean that the transaction will have no tax consequences, as gain must be recognized in a like-kind exchange to the extent that the exchanged property rights are not equal in value.80 If the terms of the transfer by the U.S. affi liate are such that the transfer would constitute a license instead of a sale (e.g., the cross-licenses are nonexclusive licenses or the cross-licenses can be terminated at will by either party), then the cross-license may not constitute an “exchange” protected by Code Sec. 1031.81

C. Nonrecognition Provisions for Offshore Capital Contributions and Stock Transfers

The transfer of intangibles to a foreign corporation or partner-ship qualifi es for nonrecognition treatment subject to special rules applicable under Code Sec. 367 if it constitutes a “transfer of prop-erty” under Code Sec. 351 (in the case of a transfer to a foreign cor-poration) or under Code Sec. 721 (in the case of a transfer to a for-eign partnership). If the transferor that receives stock in a corpora-

tion does not qualify for tax-free treatment under Code Sec. 351, then the value of the stock re-ceived will be considered to be an advance royalty to the extent not attributable to other property or services transferred or rendered to the corporation, with the value of stock received for services also included in income at the time received.

Alternately, if, in exchange for a partnership interest, a person contributes a right of use of an intangible, or grants some other right in an intangible that does not constitute a “transfer of prop-erty” for purposes of Code Sec. 721, then the transfer potentially should be considered an advance royalty, equal to the value of the partnership interest received. The IRS’s position is that a transfer of intangibles may not qualify as a “transfer” for Code Sec. 351 purposes unless, absent the ap-plication of a nonrecognition provision, the transfer would constitute a sale or exchange,82 with the IRS position narrower than the case law, which treats a transfer as a sale even if the right is limited to a specifi c geographic area or subject to a fi eld of use restriction

The Code Sec. 367 rules pre-clude the tax-free transfer of intangibles by a U.S. corpora-tion to a foreign corporation and apply only with respect to “intangible property,”83 which for this purpose includes patents, inventions, formulae, processes, designs, patterns and know-how; copyrights and literary, musical or artistic compositions; trademarks, trade names and brand names; franchises, licenses and contracts; methods, programs, systems, procedures, campaigns, surveys, studies, forecasts, estimates, cus-

tomer lists and technical data; and similar items. However, the term does not include an item that has no substantial value independent of an individual’s services.84 Code Sec. 367(d) does not apply to the transfer of foreign goodwill or going-concern value, which is the residual value of a business conducted outside the United States after subtracting the value of all other tangible and intan-gible assets. Foreign goodwill or going-concern value includes the right to use a corporate name in a foreign country.85 The regulations under Code Sec. 367(d) contain special rules regarding “operat-ing intangibles,” a subcategory of “intangible property,” which is any intangible property of a type not ordinarily licensed or other-wise transferred in transactions between unrelated parties for consideration contingent upon the licensee’s or transferee’s use of the property.86

Basically, when a transfer of intangible property is subject to Code Sec. 367(d), the transferor is treated as having sold the prop-erty.87 Thus, the transferor makes a fully taxable disposition, rather than a tax-free capital contribu-tion or exchange under Code Sec. 351.88 Generally, Code Sec. 367(d) treats the transferor as receiving a payment for the intangible prop-erty during each year of the useful life of the property. The transferor has deemed income only during the useful life of the property. The regulations place a 20-year cap on the time period involved.

The useful life is the lesser of (1) 20 years or (2) the period during which the property has value. If the value of the property arises from secrecy or legal protections, the useful life ends when the property is no longer secret or



37

protected. If the useful life ends unexpectedly, the transferor should have no further income. The regulations under Code Sec. 367(d) provide that Code Sec. 482 and its regulations govern the amount of the income under Code Sec. 367(d). If the foreign corporate transferee pays royal-ties or periodic payments to an unrelated person for the use of the intangible property, those payments reduce the amount of income imputed to the transferor under Code Sec. 367(d). Thus, the transferor is deemed to have received only the net amount.

VI. Transfer Pricing—General Application and Regulatory History of Code Sec. 482A. Background

A multinational enterprise con-ducting international operations is required to allocate its total profi t among the jurisdictions in which it operates in a manner that permits each country to tax an appropriate portion of its total income, while at the same time avoiding double taxation of the same income by more than one country, regardless of whether the enterprise operates worldwide through a single legal entity or through a separate legal entity in each country. For an MNE operating through one or more separate affi liates, domiciled in each country, intercompany transfer pricing involves setting an appropriate level of compen-sation on transactions between affi liates or other related parties, also known as “intercompany transactions.” Such intercompany

transactions might include set-ting a royalty rate on a license of patents, trademarks or other intan-gibles by one affi liate to another, or setting a sales price on goods manufactured by one affi liate and sold to another affi liate for further manufacturing or distribution. The royalty rate on a license between affi liates, the sale price of goods sold in a transaction between affiliates, the amount paid for services performed by one affi liate for another and the compensation paid in any other intercompany transaction are all referred to as transfer prices. Transfer pricing is the most important area of audit and litigation controversy in the international tax arena because they are easily identifi ed and po-tentially involve large amounts of revenue.89

It is an important fact that many U.S. MNEs are more concerned with increasing the amount of foreign-source income available for U.S. tax purposes than about deferral potentials, as their ef-fective U.S. tax rate is less than their effective foreign tax rate, and such a U.S. corporation that has incurred foreign taxes (either directly or through foreign sub-sidiaries) in general can claim a foreign tax credit for those taxes, but only against the U.S. tax im-posed on foreign-source income. Thus, the more foreign-source income earned by such a U.S. MNE, the larger the foreign tax credit potentially available.90

B. The Intersection of Code Secs. 367 and 482

The Code Sec. 367 rules were materially modifi ed in 1984 to prevent the tax-free transfer of even foreign intangible rights, and under the current rules, if a U.S. parent transfers intangible assets

to a foreign subsidiary, the U.S. parent is deemed to sell the in-tangibles to the foreign subsidiary for a sales price that is contingent upon the use of the intangibles, the effect of this provision requir-ing an annual imputation to the U.S. parent of the amount that would have to be paid as a roy-alty if the intangibles had been licensed instead of transferred. However, such amount imputed under Code Sec. 367(d) (governing outbound transfers) is treated as U.S.-source income even though imputed from a foreign corpora-tion, whereas a royalty paid on a license generally would be treated as foreign-source income, thus creating the need for foreign source income treatment in order to use available foreign tax credits in a tax-effi cient manner, with the consequence being a tendency that intangibles generally will be licensed and not transferred to foreign subsidiaries.

The outbound transfer rules of Code Sec. 367 rules enforce the Code’s requirement that the income stream derived from U.S.-developed intangibles is taxed to the U.S. parent and accordingly limits the ability of a U.S. MNE group to transfer income-pro-ducing intangibles to foreign subsidiaries in an effort to achieve a deferral of U.S. tax. This result-ing treatment of intangible income imputed under Code Sec. 367 as U.S.-source income generally will make it desirable to license intangibles to foreign subsidiaries (instead of transferring the intan-gibles) since royalties paid on a license will be treated generally as foreign-source income. However, regardless of whether or not intan-gibles are transferred or licensed, transfer pricing issues will com-monly arise as to the amount of

38

royalty or deemed imputed royalty derived from intangibles licensed or transferred to foreign subsid-iaries, with the outbound rules of Code Sec. 367 in tandem with the arm’s-length rules of transfer pricing under Code Sec. 482, as-suring that a royalty equivalent amount of intangible income from U.S.-developed intangibles is taxed to the U.S. developer of the intangibles.

C. The Code Sec. 482 Rules

Armed with Code Sec. 482, the IRS is able to allocate income, deductions and other tax items among related taxpayers to pre-vent the evasion of taxes while simultaneously assuring that the income of related taxpayers is clearly refl ected on their tax returns. IRS regulations issued in 1968 contain the general prin-ciples for determining:

the amount of compensation for services;the royalty rate for a license of intangible property;the price for the sale of in-ventory or other tangible property;the amount of rent on leases of tangible property; and

the rate of interest on related party loans, all in the context of related party inter-company transactions.

Revised regulations issued in 1994 provide detailed guidance on the selection of an appropriate transfer pricing method, the pro-cess of measuring comparability and the selection of methodolo-gies based on particular facts and circumstances of a related party inter-company transaction.

The IRS initially applies the Code Sec. 482 rules during the course of an audit in examining the taxpay-er’s income or deductions arising out of intercompany transactions, and if the IRS proposes an adjust-ment, the “burden of proof” shifts to the taxpayer, who is required to show that the proposed IRS ad-justment is capricious, arbitrary or unreasonable by using generally one of two approaches:

The taxpayer represents that the transfer prices selected and used adequately comply with the regulations, thus ne-cessitating the rejection of the IRS proposed adjustment.The taxpayer simply offers a compromise transfer price to settle the controversy and

mitigate any penalties, which IRS might statutorily assess.

Of course, if the transfer pricing controversy is not settled between the taxpayer and IRS, and assum-ing the taxpayer has exhausted its IRS appellate remedies, the courts become the venue for settlement, with the courts exhibiting of late a tendency to substitute their own analysis and judgment for that of both the IRS and the taxpayer.

By its terms, Code Sec. 482 ap-plies only to transactions between two or more organizations, trades or businesses owned or controlled, directly or indirectly, by the same interests. Thus, Code Sec. 482 does not apply to transactions between parties that do not have common ownership or control. For purposes of Code Sec. 482, “controlled” re-fers to any kind of direct or indirect control. The regulations provide that “control” may result from the actions of two or more taxpayers acting in concert or with a common goal. Formally separate ownership arrangements will not avoid Code Sec. 482 if control exists in real-ity. There is no bright-line test for control under Code Sec. 482. Code Sec. 482 applies regardless of whether the organizations, trades or businesses are organized in the United States or are incorporated. Code Sec. 482 commonly applies to transactions between a U.S. cor-poration and its foreign subsidiary, or between a foreign corporation and its U.S. subsidiary.

Further, Code Sec. 482 also may apply to transactions between two foreign entities. The basic purpose of Code Sec. 482 is to ensure that taxpayers clearly refl ect income from controlled transactions and do not avoid income from such transactions. Code Sec. 482, at least in theory, places a controlled taxpayer on a tax parity with an

Illustration 6 The Intersection of Code Sec. 367 and Code Sec. 482

FOREIGNSUBSIDIARYINTANGIBLES

U.S.PARENT

CORPORATION

TRANSFER IS DEEMED SALE

100% OWNED

IMPUTED INCOME

If a U.S. parent transfers intangible assets to a foreign subsidiary, the U.S. parent is deemed to sell the intangibles to the foreign subsidiary for a sales price that is contingent upon the use of the intangibles, the effect of this provision requiring an annual imputation to the U.S. parent of the amount that would have to be paid as a royalty if the intangibles had been licensed instead of transferred.

Such amount imputed under Code Sec. 367(d) (governing outbound transfers) is treated as U.S.-source income even though imputed from a foreign corporation, whereas a royalty paid on a license generally would be treated as foreign-source income (thus the need for foreign source income treatment in order to use available foreign tax credits in a tax-efficient manner), with the consequence being a tendency that intangibles generally will be licensed and not transferred to foreign subsidiaries.



39

uncontrolled taxpayer. The stan-dard followed generally is that of an uncontrolled taxpayer deal-ing at arm’s-length with another uncontrolled taxpayer. In certain areas, however, Code Sec. 482 may either impose or allow a dif-ferent standard. Thus, for example, the Code Sec. 482 regulations con-tain safe harbor rules for interest, certain rents and certain payments for services. Further, the last sen-tence of Code Sec. 482 allows the IRS and the courts to judge pay-ments for intangible property on a look-back basis (i.e., taking into account the income earned by the intangible property after the year of the transfer). In general, only the IRS may invoke Code Sec. 482.

Thus, a taxpayer generally cannot apply Code Sec. 482 at will or force the IRS to do so. Once the IRS has made an adjustment, however, a taxpayer should have the right to the appropriate correlative allocations. Despite the general rule against in-voking Code Sec. 482, a controlled taxpayer may report its taxable income based on arm’s-length prices (on a return that is timely fi led, including extensions) even if those prices differ from the prices actually charged. The regulations do not, however, permit a taxpayer to decrease taxable income on an untimely or amended return based on adjustments with respect to con-trolled transactions. In an extreme case, a domestic taxpayer may try to shift income to a foreign entity that did not really earn the income. The IRS may then use Code Sec. 482 to allocate 100 percent of the income to the domestic taxpayer. More com-monly, Code Sec. 482 results in a partial allocation of income.

D. The “Arm’s-Length” Principle

The “arm’s-length” standard has been the benchmark in

determining transfer prices for intercompany transactions since the IRS issued regulations under a predecessor to Code Sec. 482 in 1935. Pursuant to this standard, the appropriate transfer price of a transaction between two related parties is that price or range of prices that would have been bar-gained for and agreed upon but for the fact that the related parties had not been related and accord-ingly deemed “uncontrolled,” and is essentially a fair market value standard that requires parties to make hypothetical determinations that are fact-dependent, judgmen-tal and subjective in nature. Thus, the room for controversy.

The transfer pricing regulations of Code Sec. 482 reject as unsound formulary methodologies, includ-ing those adopted by most states within the United States, pursuant to which state tax apportionment methodologies typically allocate income to activities within the state on the basis generally of a three-factor formula.91 The formu-lary approaches used in Advance Pricing Agreements (APAs) in the fi nancial transactions area differ from the formulary methodologies used by the state or elsewhere in the federal income tax law in that the APA approaches attempt to allocate income based on the relative values of economic func-tions performed in earning income and attempt to reach a reasonable economic answer, while other for-mulary methodologies are purely arbitrary, thus reaching a rational and economic result only coinci-dentally.

E. Reliance on Comparable Uncontrolled Transactions

The Code Sec. 482 regulations essentially require the use of com-parable uncontrolled transactions

in setting intercompany transfer prices and additionally place strong emphasis on comparability of both the parties and the trans-actions in determining transfer prices for related-party transac-tions,92 thus requiring the use of the transfer pricing methodology that produces the most reliable measure of an arm’s-length price in view of the data available and its comparability to the transfers at issue. The regulations93 list important factors in determining a comparable royalty rate for li-censes of intangibles, although in practice, assuming a valid com-parable transaction does not exist, the methodology typically used is in the form of a profi t split or alter-native analysis used to derive an appropriate royalty rate that will yield the desired result.

The fi nal Code Sec. 482 regu-lations provide guidance with respect to the use of three specifi c methods for valuing intangibles.94 The comparable uncontrolled transaction method searches for licenses of “comparable” intangi-bles to determine an arm’s-length royalty rate, while the comparable profi ts method determines a roy-alty rate that provides the requisite level of net profi t to the licensee, based on the profi t level indicators of comparable companies.

Additionally, the Code Sec. 482 regulations provide two forms of profi t split methods: the comparable profi t split which is based on splits from comparable arrangements involving compa-rable companies, although they are difficult to find in the real world; and the residual profi t split method, which allocates the com-bined income between the related parties by fi rst allocating income to each party based on the arm’s-length return each should receive

40

for performing specifi ed functions, with the remaining income allo-cated between the parties based on some reasonable formula or ratio based on the facts and cir-cumstances, with this residual amount presumed to be attribut-able to intangibles, this residual split being similar to a type of “excess earnings method.” Finally, the regulations relating to sales of tangible property set forth three methods that basically require the use of comparable uncontrolled transactions, although alternative methods are contemplated in the absence of comparable transac-tions, including the comparable uncontrolled price method, the resale price method and the cost-plus method.95

F. Transfer Pricing Methodologies

1. The Comparable Uncontrolled Price Method. The comparable uncontrolled price method is used when there are comparable uncontrolled sales of the same or similar products by either the taxpayer or a competitor; for ex-ample, a foreign company in the business of manufacturing that sells inventory of its manufactured product to both U.S. wholesale distributors and to unrelated such wholesale distributors located in the United States.96

2. The Resale Price Method. The resale price method is used ascertain the proper markup for a related-party distributor by at-tempting to locate and identify resale profi t margins of unrelated distributors in the business of distributing identical or similar products and that in the distri-bution process perform similar functions such as advertising, product promotion and in-depth marketing functions, but this method cannot be used if such

related distributors so located and identifi ed own and employ valuable marketing intangibles (as comparable markups will be diffi cult to isolate), perform ad-ditional pre-sale manufacturing processes or own manufacturing intangibles used by another af-fi liate in the manufacture of the product. Such a scenario is found, for example, wherein a domestic (i.e., U.S.) parent purchases from a foreign subsidiary products manufactured with patents or other intellectual or marketing intangibles owned by such do-mestic parent, as illustrated by the facts present in the landmark transfer pricing case, Bausch and Lomb.97 In this case, the resale price method could not be used, as no return for its manufacturing intangibles was given the domes-tic parent. A similar scenario is present in a situation involving consumer products purchased by a domestic subsidiary from a for-eign parent if the product’s relative profi tability is a material conse-quence of extensive marketing efforts by such domestic subsid-iary, a signifi cant presence in the market as a result of the efforts of the domestic subsidiary, or the domestic subsidiary’s ownership of valuable marketing intangibles such as trademarks or tradenames. The resale price method is similar to the comparable profi ts method in situations involving signifi cant adjustments to account for differ-ences in “below-the-line” cost structures, as it specifi cally rati-fi es using an operating margin as a profi t-level indicator for determin-ing appropriate transfer prices.98

3. The Cost-Plus Method. The “cost-plus” method is frequently used to determine transfer prices for manufacturers selling to relat-ed distributors, as illustrated by a

foreign subsidiary manufacturing products with manufacturing in-tangibles owned by its domestic parent, which in turn are sold to other affiliates that market the products. In this instance, a markup or profi t margin would be calculated based on the for-eign subsidiary’s manufacturing costs in order to give the manu-facturing subsidiary a profi t that is comparable to that earned by un-related manufacturers performing the same kinds of manufacturing functions and assuming similar risks.99

4. The Comparable Profits Method. The comparable profi ts method typically is used in trans-fer pricing situations when other methodologies are either inappli-cable or inaccurate due to a lack of comparability and similarity in data between compared entities and the taxpayer entity, and func-tions by identifying comparable companies performing similar functions in order to determine various profi tability ratios such as operating margins, return on assets, et al., after making a provision for adjustment incident to the various comparables’ data in an effort to resemble the controlled taxpayer, typically by developing a range of profi t levels from the selected and adjusted comparables and then using these profi t-level indi-cators to determine the amount of profi ts for the controlled taxpayer, allowing the controlled taxpayer to interpolate or derive a transfer price. This methodology is useful in various situations, including certain wholesale distributors (to which a resale price method might be applied) or manufacturer (to which the cost-plus method might be applied), both contingent upon the availability of adequate data. Additionally, this method can be



41

useful as a form of “benchmark-ing” or as a “sanity check” to compare for reasonableness in testing transfer prices derived in various situations, by both taxpayer and IRS, in an effort to resolve transfer pricing disputes at the administrative level as an attractive alternative to protracted and expensive litigation.100

5. The Profi t Splits Method. In transfer pricing situations wherein both controlled and related parties own self-developed or purchased intangibles, the profit splits method is generally prevalent as the methodology of choice and is diverse enough to feature one version which allows for profi ts to be split based on how comparable arrangements might split them and another version which initially allocates a return to identified and normally routine functions performed by each party, with any remaining or residual split based on appropriate allocation factors specifi c to the facts and circumstances in an attempt to determine the relative value of the intangibles owned by each party.

VII. Quest for Transfer Pricing “Comparables”A. Introduction

Transfer pricing law and analysis is in the application of the essentially straightforward concepts embod-ied in the facts and circumstances of individual cases and is such in both presentation and analysis. Al-though relatively few in number, the seminal transfer pricing cases refl ect the evolution of Code Sec. 482 as well as the policy evolution based on the planning patterns

evident in these cases since its predecessor, Code Sec. 45. Code Sec. 45 was enacted in the late 1920s to counter sophisticated tax planning in shifting income untaxed by U.S. hands to low and no-tax jurisdictions, as self-evident in the 1936 landmark transfer pricing case of Asiatic Petroleum,101 with prospective principal cases involving major MNEs, both domestic- and for-eign-based, and tried in the U.S. Tax Court, U.S. Court of Claims, U.S. District Courts and the U.S. Circuit Court of Appeals.102

To date, these principal cases have not embodied or been tried subject to the medicinal and profound theoretical changes enacted by the Tax Reform Act of 1986 (the “commensurate with income requirement”), although a generation of these soon will germinate and multiply, as those pricing issues involving related parties are absent the arm’s-length discipline of separate self-interest, substituted by an apparent merger of such interests.103 Although the Code Sec. 482 regulations permit some adjustment to uncontrolled transactions that are not precisely comparable in an effort to make them comparable, the method will be treated as the most di-rect and reliable measure of an arm’s-length price only if the dif-ferences have no effect on price or are minor and have a defi nite and reasonably ascertainable effect on price.104

Essentially, most transfer pricing cases (over 350 cases decided to date under Code Sec. 482) involve a signifi cant controversy about whether comparable uncontrolled transactions or comparable par-ties exist because of differences between the intercompany trans-actions under examination and the

potential comparable transactions or parties, regardless of whether the methodology used compares actual transactions105 or gross or net margins of comparable parties,106 and further subject to the inherent individual facts and circumstances of the particular controlled taxpayers and the transactions at issue, lending to transfer pricing the term labeled upon valuation and appraisal pro-fessionals as an evolving body of knowledge that is more art than science.107

The concept of comparability only can be learned theoretically, without a working knowledge of the principal transfer pricing cases summarized briefl y below, as it generally is this concept that is at the root of the controversy in such litigation, and it is through these cases in this evolving body of knowledge that we have pa-rameters as practitioners to guide taxpayers through the hazardous corridors to mitigate or avoid costly transfer pricing penalties as well as unpleasant adminis-trative controversy or expensive and protracted transfer pricing litigation. There are several semi-nal and principle transfer pricing cases in the period from inception of Code Sec. 45 in the late 1920s, as statutory predecessor to Code Sec. 482, past the turn of the cen-tury (including the DHL decisions as the century turned and the fate of the U.S. Tax Court was dra-matically overturned (by the U.S. Court of Appeals) in 2002), and the sampling below clarifi es in a practical manner the concept of comparability, more subjective a concept than most in the U.S. tax law, and “more art than science,” all as applied to the particular facts and circumstances of these leading cases.

42

The principle transfer pricing cases tried under Code Sec. 482 and its predecessor (Code Sec. 45) refl ect the evolution of transfer pricing. For the most part, these cases involved large multinational corporations (MNEs), refl ecting a broad range of global economy sectors as well as the state of the art in terms of international tax planning methodologies from approximately 1935 to date (i.e., from Asiatic Petroleum in 1935 to DHL in 2002). The case results have provided an important base for the evolution of regulatory guidance in the transfer pricing arena, although none of these principal cases to date have ad-dressed changes enacted to Code Sec. 482 by the 1986 Tax Re-form Act, adopting the so-called “commensurate-with-income” standard, which applies when an intangible is transferred in a con-trolled transaction for a lump-sum payment, wherein such a lump-sum payment made for the transfer of the intangible in a controlled transaction is treated as an ad-vance on an income stream of an arm’s-length transaction, which must be commensurate with in-come over the useful life of the intangible (or such period covered by the agreement, if shorter). The determination of the appropri-ate arm’s-length royalty stream equivalent must take into consid-eration any projected sales by the licensee and, using an appropri-ate discount rate, must include a present value calculation of the lump-sum amount.108

Although in these principle cases, the purpose of the cor-porate structure producing the pricing issue was an interesting consideration, it was not the es-sence of the transfer pricing issue at hand; rather, the pricing issue

was resolved on the basis of the particular goods, service, intan-gible or capital transaction at issue, and how such transaction would have been structured by unrelated parties dealing on an arm’s-length basis. The concept of risk is a common element in each of these cases. Its presence can be evaluated to determine how unrelated parties dealing at arm’s-length compensate the risk-taker, as such economic risk creates substance for tax pur-poses, and further, as evidenced in many of these cases, the courts are much more comfortable in resolving pricing issues where comparable bases are found—such transactions are refl ective of the marketplace’s foundation. In those cases where there are no comparable uncontrolled party transactions or transactions can-not be appropriately adjusted to eliminate noncomparble factors, the transfer pricing issues must be resolved on the basis of the facts and circumstances of the case as well as the best evidence available.

The results of these principal cases lean heavily in favor of taxpayer, with the government winning few cases, some taxpayer victories being “shutouts” and oth-ers compromised by splitting the proposed and actual allocations, indicating that the normal burden of proof carried by the taxpayer may not be as signifi cant a matter as fi rst envisioned. It is noted that although the sample is small, it is representative; however, none of these leading cases tried to date have been so tried under the “commensurate-with-income” standard imposed by 1986 legis-lation, as the time it takes these cases to arrive for litigation can be quite protracted due to their

prior administrative compromise. For those controversies unsettled, the road to the courts is, indeed, “long and winding.”

B. Comparability Viewed Through a Summary of Case Law Under Code Sec. 482

1. Ciba-Geigy Corp. Ciba-Geigy109 involved the appropriateness of a 10-percent royalty rate paid by a U.S. subsidiary to a Swiss Parent on an agricultural herbicide pat-ent, with an offer by Dupont to pay a royalty of 10 to 12.5 percent held to be a valid comparable. The IRS asserted multiple theories to the effect that the parties had en-tered into a joint and cooperative R&D agreement that should have resulted in the U.S. subsidiary re-ceiving a royalty-free license and further that the royalty rate should have been six percent instead of 10 percent. The Tax Court rejected this theory and found that a fee should have been paid for the re-search activities. Also interesting in this case was the introduction of evidence by the government, which has subsequently been cited prospectively by taxpayers, that a licensor generally retains 25 percent of the profi ts from the ex-ploitation of the intangible, while the licensee generally earns 75 percent of the profi ts for its efforts in exploiting the intangible.

2. U.S. Steel Corp. In U.S. Steel,110 the taxpayer was a U.S.-based, vertically integrated producer of steel products owning mines in the United States and abroad. Initially, the ore was transported to the United States in chartered vessels owned by independent companies. Then the taxpayer formed a Bahamian subsidiary for the purpose of chartering ore carri-ers for transporting iron ore mined aboard, with it accordingly entering



43

into shipping agreements with third parties, which assumed pre-existing obligations of the U.S. company, which also guaranteed such ship-ping agreements. The IRS argued that U.S. Steel’s wholly owned shipping company (“Navios”), was charging too much for ship-ping ore from Venezuela to U.S. ports. The Tax Court concluded that a Code Sec. 482 reallocation was appropriate in the circum-stances, but the decision of the Tax Court was reversed on appeal: The Second Circuit found that no such adjustment was appropriate, accepting as comparable shipping rates the rates charged by Navios to unrelated steel producers, and further rejecting the government’s arguments that U.S. Steel could have obtained lower rates from unrelated shippers because of the size of its shipments.

3. Perkin-Elmer Corp. In Per-kin-Elmer,111 a U.S. corporation (“Perkin-Elmer,” or “PE”) sold parts and equipment to its Puerto Rican subsidiary (“PEEC”), which manu-factured fi nished products (highly specialized optical equipment) with intangibles licensed by PE to PEEC. PEEC’s fi nished products were sold back to PE. The court examined the purchases and sales of tangible property by PEEC and the license of technology by the taxpayer to PEEC, focusing on transactions between taxpayer and unrelated parties as well as between unrelated parties (not in-cluding the taxpayer) as potential comparables. The court applied the resale price method to the sales by PEEC to PE, using resale margins derived by PE from the sale of products purchased from unrelated parties and treating the arrangement as an exclusive distributorship arrangement, but the court specifi cally rejected the

argument that an exclusive distrib-utorship results in high price items necessarily having higher margins and further, basing its adjustment on actual prices paid on PE’s resales (not invoiced amounts), making no adjustments request-ed by the government, due to the absence of data quantifying the adjustments requested.112 Finally, the court increased the royalty rate on products manufactured by PEEC (with the exception of one product line—lamps) based on an earlier licensing arrangement by the taxpayer to a third party. Throughout Perkin-Elmer, the court required an exacting degree of specifi city and certainty before it would accept any comparable or adjustment proposed by either side, it being less concerned with the methodology employed than with the comparability of the third party data to the related party transactions.

4. Westreco Inc. In Westreco,113 the court rejected the IRS’s use of an unadjusted and unanalyzed group of companies that were selected solely on the basis of their Standard Industry Clas-sifi cation Codes in determining a cost-plus markup for contract research. This case is notable not only for the controversy between taxpayer and IRS counsel as to procedural matters, but also for eliminating the use of industry averages in determining transfer prices, with the fi nal Code Sec. 482 regulations clarifying that such use of industry averages will not meet comparability re-quirements.114

5. Nestle Holdings. Nestle Holdings115 held that the value of a transferred intangible cannot be determined solely by applying a “relief from royalties” method-ology, under which the value of

an intangible is determined with reference to the present value of the royalties the transferee would be requested to pay to use the trademarks. The Appeals Court found that this methodology un-dervalues trademarks in the case of an outright transfer, because the transferee in a trademark sale has the right to determine when and where to use a mark, including the determination of which prod-uct lines will bear the mark, and is not subject to temporal or other limitations on a licensee’s use of the trademark.116

6. DHL Corp. In the DHL case,117 the IRS sought to allocate, under the authority of Code Sec. 482, additional capital gain in-come to DHL for the 1992 sale of the DHL trademark to DHLI/MNV for $20 million, arguing at trial that the trademark had a $300 million value at the time of the sale, while DHL contended on essentially two grounds that an allocation of additional capital gain income was inappropriate. It fi rst contended that $20 mil-lion was an arm’s-length price, arguing that DHL owned only the rights to the U.S. trademark (as opposed to ownership of the trademark worldwide, which would be worth more). DHL further contended that the $50 million value of the trademark that was considered during the negotiations established a ceiling on the trademark’s value. DHL explained that the $20 million value was established based on a determination that DHLI/MNV’s other assets (both tangible and in-tangible) were far more valuable than the trademark.

In conclusion of this aspect of the DHL saga, the Tax Court held that the worldwide DHL trademark had a value of $100

44

million at the time of its sale, specifically rejecting DHL’s argument that $80 million of this gain should be allocated to DHLI because DHLI was the de-veloper of the trademark within the meaning of the developer-as-sister regulations, and held that the worldwide DHL trademark had a value of $100 million at the time of its sale. The court also rejected DHL’s argument that $80 million of this gain should be allocated to DHLI because DHLI was the developer of the trademark within the meaning of the developer-assister regula-tions. Accordingly, an additional $80 million in capital gain in-come was imputed to DHL.118 The Ninth Circuit reversed the Tax Court on the royalty, trade-mark purchase price and penalty issues, based on its focus on the 1968 regulations (the tax years at issue in DHL were covered by the 1968 regulations) and found that DHLI developed the non-U.S. trademarks because it had spent in excess of $340 million in the preceding 10-year period promoting in various ways the mark outside the United States, while DHL had promoted the mark only in the United States. As the economic owner of the non-U.S. rights to the DHL trademark, the Ninth Circuit found that DHLI owed no roy-alty for the use, exploitation or purchase of a mark that it had developed.

This conclusion largely elimi-nated the IRS adjustments against DHL. The Ninth Circuit then correspondingly eliminated the accuracy-related penalty im-posed by the IRS, fi nding that the Bain “comfort” letter established that DHL had acted reasonably. Further, the result in DHL was

supported by the Ninth’s Cir-cuit fi nding that DHLI was still conducting business in an im-mature or undeveloped market for the years 1982–1992. Hence, it appears that the Ninth Circuit assumed that all expenses were developmental and not routine. In this instance, it is clear that some expenses are routine in maintain-ing the status of the trademark in the market while others may be earmarked for further develop-ment and enhancement of the trademark. It also appears that the Tax Court required DHL to establish that DHLI expenditures above this threshold actually were incurred relevant to the develop-ment of the non-U.S. trademark rights, with the Ninth Circuit not requiring the level of specifi city as that of the Tax Court.119

7. Compaq Computer Corp. In Compaq Computer Corp.,120 Compaq purchased components for the personal computers that it manufactured from its Singapore subsidiary (Compaq Asia), and also manufactured those same components in the United States as well as made additional pur-chases from a number of unrelated manufacturers. Compaq faced the burden of establishing that the IRS notice of defi ciency, in which the IRS applied a comparable profi ts method, was arbitrary, capricious or unreasonable and that the prices that Compaq paid to Compaq Asia were arm’s length. After conclud-ing that the IRS’s transfer pricing results were unreasonable, primar-ily because of large discrepancies between the notice of defi ciency and the government’s position in the litigation, the court addressed the appropriateness of the prices charged by Compaq Asia, basing its decision on the regulations in effect prior to January 1, 1994,

focusing only on the application of the comparable uncontrolled price (CUP) method.

Compaq offered purchasing data from 14 unrelated manufac-turers as its comparables, which the court accepted because, while not identical to the pur-chases from Compaq Asia, they were suffi ciently similar to allow reasonable price adjustments to reflect any differences. The court considered adjustments for minor physical differences in the products and differences in production time, design services provided by Compaq Asia but not by the unrelated manufacturers, higher freight and duty costs for the purchases from Compaq Asia, compensation due to Compaq Asia for setup and cancellation charges, and inventory risk borne by Compaq Asia because of raw material purchases based on non-binding forecasts.

The court rejected the govern-ment’s contention that volume discounts should apply to Com-paq Asia’s sales, noting that the evidence indicated that the prices charged by the unrelated manufacturers were not related to volume, but that rather Compaq was in such a dominant market position that it was able to receive the best prices from all manufac-turers, regardless of volume. The court also rejected the govern-ment’s contention that the high profi t margins earned by Compaq Asia were indicative of an infl ated purchase price paid by Compaq. The court noted that the relative cost structures of the related and unrelated manufacturers were ir-relevant to the CUP analysis and that the evidence established that the prices charged by Compaq Asia were consistent with arm’s-length market prices.



45

VIII. Cost-Sharing Agreements (CCAs) and Buy-In/Buy-Out of Developed IntangiblesA. Background

Generally, the fi nal regulations contain a basic buy-in require-ment that mandates controlled participants to make appropriate allocations for transferred tangible and intangible property to refl ect arm’s-length consideration121 and provide further that any changes in the controlled participant’s interest in the arrangement may necessitate further adjustments, including terminating or exiting the arrangement (i.e., the buy-out), while buy-in payments may be netted against any other payments owed to the partici-pant122 While these rules may at fi rst blush appear fl exible, they do not provide a safe harbor for valuing intangibles apart from the traditional rules set forth in the regulations for intangibles, thus making unresolved the issues under the buy-in rule for work-in-progress or noncommercial intangibles or preexisting intan-gibles that are being upgraded or replaced. Further, the rules and available guidelines for “buy-in” payments apply equally to “buy-out” payments within the context of developed intangibles.

B. Diffi culties in Buy-In and Buy-Out Valuations

If a controlled participant to a cost-sharing agreement makes intangible assets such as pre-ex-isting intangibles, or unfi nished “work-in-process” R&D for in-tangible projects available to the

other participants for purposes of the cost-sharing agreement, an arm’s-length “buy-in” payment must be made to the owner for the use of the intangible assets.123 Certain items not qualifying as identifi able intangible assets can be considered value or com-petitive factors and infl uences,124 although the existence of many of these characteristics may in-dicate the existence of valuable nonroutine intangible assets or comprise a part of an overall mar-keting intangible. Determining the amount of the buy-in (or buy-out) payment involves diffi cult fact and circumstance coupled with valua-tion issues that can directly affect the buy-in or buy-out mechanism contained in cost-sharing agree-ments. Such valuation issues arise when the buy-in payment is made for pre-existing intan-gible assets, although identifying the appropriate valuation model components, business synergies and useful lives of these apparent pre-existing intangible assets can be problematic.

These intangibles can include the following:

Marketing-related intan-gible assets (e.g., trademarks, tradenames, brand names and logos)Technology-related intangible assets (e.g., process patents, patent applications, technical documentation, such as labo-ratory notebooks, technical know-how and work-in-pro-cess R&D)Artistic-related intangible as-sets (e.g., literary works and copyrights, musical composi-tions, maps and engravings)Data processing-related assets (e.g., proprietary computer software, software copyrights, automated databases and in-

tegrated circuit masks and masters)Engineering-related intangible assets (e.g., industrial design, product patents, trade secrets, engineering drawings and schematics, blue prints and proprietary documentation)Customer-related intangible assets (e.g., customer lists, customer contacts, customer relationships and open pur-chase orders)Contract-related intangible assets (e.g., favorable supplier contracts, license agreements, franchise agreements and noncompete agreements)Human capital-related intan-gible assets (e.g., a trained and assembled workforce, employment agreements and union contracts)Location-related intangible as-sets (e.g., leasehold interests, mineral exploitation rights, easement, air rights and wa-ter rights)Goodwill-related intangible assets (e.g., institutional good-will, professional practice goodwill, personal goodwill of a professional, celebrity goodwill and general business going-concern value)125

Complexity increases when the intangible asset involves unfinished “work-in-process” R&D, although several primary valuation models are available to resolve these calculations, including the discounted cash flow (DCF), relative value and option models. These models can be further categorized based on assumptions about the business growth into stable-growth, two-stage and three-stage models, with the measurement of earnings and cash fl ows adjusted to match the special characteristics of the com-

46

pany or transaction being valued. For the use of multiples, the price can be expressed in various terms, and the multiples themselves can be calculated by using comparable companies in the same business, from cross-sectional regressions that use the broader universe or from fundamental analysis.126

Under the DCF models, the value of a business generally is the future expected cash flow discounted at a rate that refl ects the riskiness of the cash fl ow. Un-der the relative valuation model (sometimes called the “account-ing approach”), the importance of earnings of the business entity is stressed. The third approach uses an option-pricing model, which estimates the value of assets that have option-like characteristics. Generally, options are derivative securities that derive their value from underlying assets. These traditional valuation models (e.g., discounting projected cash flows, earnings multiples and option-pricing) may be highly speculative in the context of the buy-in payment for work-in-process intangible assets simply because there may be little or no reliable cash fl ows or historical sales or profi ts on which to base projections and calculations, and further, these quantitative models do not accurately measure the value of “synergy” which refers to the potential additional value gained from combining two busi-nesses or companies, either from operational or fi nancial sources. Stated another way, a whole is greater than the sum of the parts.

Under cost-sharing agreements, the issues are generally limited to:

which costs are shared under the agreement;

how costs are to be shared among the participants in the agreement;which values are attributable to intangibles developed prior to use in the agreement (the “buy-in”); and finally,what are the administrative requirements for the IRS to respect the agreement.127

Assuming that a controlled partici-pant to a cost-sharing agreement makes intangible property available to the other participants for purpos-es of the agreement, an arm’s-length “buy-in payment” must be made to the owner for the use of the intan-gible, which is generally in the form of either pre-existing intangibles or unfi nished “work-in-process” R&D for intangible projects. As discussed in this section, the IRS has recently issued FSAs that highlight the complex issues that may arise in the determination of the necessity of, and further, the amount to be paid, as well as the form of such payment, since such a determina-tion involves diffi cult factual and valuation issues. Although the IRS has complained about perceived abuses of the buy-in process and the potential undervaluing of exist-ing intangibles used in cost-sharing agreements, such abuses seem to arise primarily in the context of CCAs established in low-tax or no-tax jurisdictions or in situations wherein such cost contributions to the CCA are inconsistent with the benefi ts and results of the arrange-ment. It is quite normal that such valuation problems arise when the buy-in is made for pre-exist-ing intangibles, as even the task of identifying the components, synergies and useful lives of these pre-existing intangibles can be challenging.128

Several possible methods have been suggested for valuing a

work-in-process buy-in, includ-ing the traditional comparable uncontrolled transactions (CUT) method and the comparable prof-its method (CPM), although for the former method, comparable uncontrolled transactions are dif-fi cult at best to fi nd, whereas the latter approach can produce wide fl uctuations in rate-of-return data and imprecise comparables due to the sheer residual nature of the approach. These fl uctuations may cause substantial year-to-year vari-ances in the valuation process. As suggested earlier, a DCF analysis may be employed, although its re-sults can be speculative at best in certain circumstances and should only be used as a “sanity check” on the best method selected, as it otherwise is prone to the distortion of results.

C. Parameters for Buy-in Payments

Parameters for establishing the value of buy-in for the projected value of the work-in-process component of an R&D project might for companies with a history of R&D projects be de-termined by using the company’s historic expected rate of returns for corporate investments, its anticipated cost of capital or some accounting method of depreciation allowance for in-process R&D that is written off for book purposes, as the fl oor and the ceiling may be the pres-ent value of the expected income stream to be derived from the in-tangible asset being developed, with such ceiling derived from the income fl ows of comparable intangibles, business projections or even the fair market value (or in some instances, market capi-talization) of the entire business unit appropriately discounted or



47

adjusted for market characteris-tics, assets not contributed and business unit synergies. In situ-ations where the business unit is either publicly traded or the subject of a recent acquisition, the business unit value might be somewhat determinable and sub-ject to various adjustments, such as reduction for any incremental value brought to the acquired unit by the purchaser.

Although several methods have been suggested for valuing a work-in-process buy-in payment including the traditional compa-rable uncontrolled transaction, the comparable profi ts method and a profi t-split approach, each of these more traditional methodologies have shortcomings in this area and can cause wide variations in value. In certain circumstances, the DCF method may be used despite its speculative nature, but one of the limitations of the DCF method is its failure to consider assets that do not produce cash fl ows currently and are not expected to produce cash fl ows in the near future, but are valuable nevertheless because of their potential to produce value for the company,129 with the valu-ator prospectively and historically forewarned that, absent favorable alternatives, prior to the stock mar-ket swoon of the past couple of years, the IRS was currently prone to using this or a similar market capitalization approach in the ab-sence of an alternative or because it yielded a favorable tax result.

A market capitalization ap-proach generally uses the price of a company’s stock as the starting place for valuation of the compa-ny’s intangible assets subject to the amount of the buy-in payment.130 The market capitalization residual method (MCRM) (a common form of market capitalization method

used by IRS in proposed adjust-ments as recently as the last stock boom) involves fi rst the estimation (i.e., preferably by a limited ap-praisal valuation calculation for each and all of a company’s in-tangible assets, albeit it a complex and subjective process, requiring the precise identification of each intangible asset, and then separately valuing each of them, again requiring more, more and more analytical and complex valuations, as well as the sheer number of valuations, thus in-volving substantially more cost in lieu of a more passive and less expensive process of simply esti-mating the value of the intangible asset comprising the cost-sharing agreement.131

Although the market capitaliza-tion method logically appears at fi rst glance to represent the “true value” of a company using all available information and based on the functioning of efficient markets, it can be argued that such a methodology does not adequately address the assump-tion that a company’s total value always equals the separate sum total of its market capitalization (as by and large, even for small and middle-sized publicly traded companies, the sum total of its authorized, issued and outstand-ing shares multiplied by such shares’ publicly traded market price equals the value of such company (for both tangible and intangible assets) on a controlling (minority) marketable basis, thus not recognizing the true value of the company nor any synergistic values.

Care should be exercised in timing and application of this method, as the price paid by a prospective acquiror may include values for such synergies, changes

in business plan or other matters not refl ective of the underlying as-set value or stock price that is the subject of the “buy-in” payment. Further, stock prices may fl uctuate over time due to many events not related to underlying asset value, such as in applying the price-to-earnings ratio approach, another market capitalization derivative which assumes the company will be worth some multiple of its future earnings in the continuing period—obvious, but diffi cult to approximate in reality and thus in practice as well.

The market-to-book ratio ap-proach assumes the company will be worth some multiple of its book value, often assumed to be or interpolated from the current multiple or the multiple of comparable publicly traded companies, creating a form of mandatory circular reasoning in order to prove the effi cacy of such methodology.

D. IRS Regulatory Response and Guidance with Respect to Buy-In Payments

1. Field Service Advice (FSA) 200023014. Through FSA 200023014, the IRS admits ap-plication of and further even suggests that the market capital-ization method might be deemed appropriate for the valuation of a buy-in, assuming certain facts and circumstances.132 This FSA also noted that a profi t-split analysis might be useful when two or more parties contribute nonroutine intangibles to the cost-sharing arrangement, although its effective application is questioned by recent commentators.133 FSA 200023014 espouses that the valuation of the buy-in payment, especially work-in-process, gen-erates complex issues as well as

48

the possibility of administrative controversy or litigation with the IRS. FSA 200223014 secondly ad-dresses the form of payment for the buy-in, allowing buy-in pay-ments in lump sums, installments or via royalty payments to parties to a cost-sharing agreement. Nothing in the regulations or elsewhere supports the proposed fi eld service advice position that buy-in royalties must continue for the life of the intangible asset, as experience suggests that many taxpayers dealing at arm’s length purposefully place a time limit on royalties that is generally shorter than the life of the intangible, though the offi cial IRS position is that on audit, it may propose a Code Sec. 482 reallocation in an attempt to increase the length of a royalty payment stream.

2. FSA 20001018. Another controversial fi eld service advice deals with buy-ins, illustrating again how important proper form is for effective cost-sharing agreements with foreign subsidiar-ies, as well as costs paid by such foreign subsidiaries for updating its technology as well as those re-spectively for special technology used in manufacturing operations. The primary question in the in-stance of this FSA was whether or not such a foreign subsidiary is re-quired to make a buy-in payment to its domestic parent for certain technology, as well as current and prospective payment to the extent of continuing or additional research in the technology area, surmising that such foreign subsid-iary is required to contribute to the acquisition of certain technology (the buy-in) and to any work done to improve or update that or other specifi ed technology (additional cost-sharing payments). Thus, in some instances, it is advisable to

incorporate additional technolo-gies into an existing cost-sharing agreement, while in others, it may be more benefi cial to have certain technologies outside the cost-sharing agreement and therefore subject to the normal arm’s-length transfer pricing rules. Further, the FSA asserts that the subsidiary must make buy-in payments over fi ve years, including three years still open under the statute of limitations, with such “statute position” allowing the IRS gen-erous opportunities to examine and subsequently become alert to any missing or omitted buy-in transaction.

While methods and approaches to the valuation of buy-in pay-ments are generally similar to buy-out payments, some differ-ences do exist. The fi rst noticeable such difference is the evaporation of termination or winding down of a cost-sharing arrangement, in that the synergies that may have ex-isted throughout the combination of joint efforts of the parties (or the comparable benchmarks) may not exist or may be severely impaired, generally resulting in the probable and signifi cant diminution of the company’s fair market value as a going concern, pre-valuation. Additionally, the value of any “work-in-process” R&D may be signifi cantly discounted without the prospective availability of the joint efforts of the parties, includ-ing the signifi cant value accorded an “assemblage of work force,” evaporated upon dissolution. Facts control the valuation result and any corresponding adjust-ments, premiums or discount factors of the valuation.

Finally, cost-sharing payments that are received by one affi liate from another are generally treated as deductible research and devel-

opment expenses to such payor affiliate, and characterizations of these payments under foreign law do not impact this generally desired result, even if the local laws of the foreign jurisdiction in question do not recognize cost-sharing arrangements.134

3. Proposed Regulations Un-der Code Sec. 482. Proposed Regulations (REG-146893-02 and REG-115037-00, Sept. 5, 2003) under Code Sec. 482 abandon the developer-assister rules that, in the absence of a bona fide cost-sharing arrangement, des-ignate a single entity within the affi liated group as the developer (or initial owner for tax purposes) of intangible property and entitled to compensation from the use or exploitation of that intangible property, without regard to legal ownership. The current Regula-tions, which were promulgated in 1994, create a distinction be-tween intangibles that exist and have value as a result of legal protection (“legally protected intangible property”), such as a trademark, and other intangibles. These Regulations apply the de-veloper-assister rules to intangible property that is not legally pro-tected intangible property. Actual legal ownership of legally protect-ed intangible property determines the right to compensation from affi liated entities that use or ex-ploit such intangible property. Proposed Reg. §1.482-4(f)(3)(i) would instead provide that the entity that is the legal owner of intangible property pursuant to the intellectual property law of the relevant jurisdiction should be the sole owner of intangible property and presumably should receive the income that the group generates from the use or exploita-tion of such intangible property.



49

If the intellectual property law of the relevant jurisdiction does not identify an owner for the intangi-ble property, the entity within the affi liated group that has control of the intangible property would be considered the sole owner of the intangible property. The Proposed Regulations would make an ex-ception if applying the intellectual property law of the relevant juris-diction would produce ownership that would be inconsistent with the economic substance of the un-derlying transactions. They suggest that Reg. §1.482-1(d)(3)(ii)(B)(2), which allows the imputation of a contractual agreement consistent with the economic substance of the transaction, would then be ap-plicable. (See Henry J. Birnkrant, Transfer Pricing for Services Is Broadly Affected by New Prop. Regs., Mostly Not for the Better, J. TAX’N, Jan. 2004.)

IX. U.S. Charitable Contributions of Intellectual and Intangible PropertiesA. Code Sec.170 Applicability, in General

Code Sec. 170 allows an income tax deduction for any charitable contribution made during the tax year. “Charitable contribu-tions” for this purpose mean gifts of money or other property to domestic nonprofi t educational, charitable and religious organi-zations exempt from tax under Code Sec. 501(c)(3), and to fed-eral, state and local governmental organizations serving a public purpose. An individual donor’s charitable contribution deduc-

tion is limited to a percentage of his or her taxable income for the year (computed without regard to net operating losses carried back to the year). The percentage limita-tions are generally 50 percent for donations to entities classifi ed as public charities and private oper-ating foundations and 30 percent for donations to entities classifi ed as private foundations. Charitable contributions in excess of these limitations may be carried forward for fi ve years and deducted in the fi rst available year for that period, subject to the applicable percent-age limitation in the particular year. A corporation may take charitable contribution deductions of up to 10 percent of its taxable income for the year (computed without regard to net operating loss car-rybacks and certain other items). Charitable contributions in excess of the 10-percent limitation may be carried forward for fi ve years and deducted in the earliest avail-able year in that period, subject to the 10-percent limitation each year.135

Code Sec. 170(f)(3) expressly disallows a deduction for a con-tribution of a partial interest in property. A “partial interest” is any interest in property that consists of less than the donor’s entire interest in the property. A contribution of only the right to use property is considered a donation of a partial interest in the property. A deduc-tion of an “undivided portion of the [donor’s] entire interest in the property” is not treated as a partial interest, however, and thus is eligible for a deduction under Code Sec. 170. For this purpose, the regulations state that an “undi-vided portion of an owner’s entire interest in property must consist of a fraction or percentage of each and every substantial interest or

right owned by the donor in such property and must extend over the entire term of the donor’s interest in such property.”

The concept of a tax benefit conditioned on giving away no less than all of one’s rights in property has company in the tax world when patents are involved. Code Sec. 1235 provides that a inventor or certain assignees of an inventor may be able to treat gain on the sale of intellectual property as long-term capital gain (rather than ordinary income), regardless of the holding period, but only if the sale involves “all substantial rights to” the intangible property or “an undivided interest therein which includes a part of all of such rights.” Under these rules, “all substantial rights to a patent” means that the rights sold may not be:

limited geographically within the country of issuance,limited in duration to a period less than the remaining term of the patent,limited to fields of use within trades or industries, orless than all the inventions covered by the patent.

Restrictions placed on donated property do not prevent a chari-table deduction for the value of the gift, but they do affect the amount of the donation.

B. Rev. Rul. 2003-28136

Rev. Rul. 2003-28 confi rms that a donation of substantially all rights in intellectual property (i.e., a patent) generates a chari-table contribution deduction, but a donation of only a subset of the rights in such property, or a dona-tion of intellectual property rights that is subject to a material con-tingency, does not. Second, the most interesting question regard-

50

ing charitable donations of such property is how to value them. Though the gift must be properly structured, the challenge comes in arriving at a valuation that will survive scrutiny.137 Rev. Rul. 2003-28 presents three scenarios in which a patent holder makes a contribution to an entity exempt from income tax under Code Sec. 501(c)(3). In the fi rst, the patent holder contributes a license to use the patent, but retains the right to license the patent to oth-ers. Not surprisingly, the IRS ruled that a donation of a nonexclusive license amounts to a donation of a “partial” interest in the patent, since Code Sec. 170(f)(3) denies a charitable contribution deduction for donations of partial interests in property, unless the partial inter-est constitutes the taxpayer’s entire interest in the property. The statute is clear on this point, but the ruling does not give attention to the spe-cifi c nature of a patent and what constitutes a partial interest in a patent. The ruling does not refer to Code Sec. 1235 for guidance as to what a “partial interest” in a patent is, but could have looked to the regulations promulgated under Code Sec. 1235, which make it clear that retaining the right to exploit a patent is a sub-stantial right.

C. Valuation Issues

In the case of contributions of intellectual property such as pat-ents and patent rights, the amount deductible is the fair market value of the property at the time of the contribution. In this context, fair market value means:

... the price at which the property would change hands between a willing buyer and a willing seller, neither being

under any compulsion to buy or sell and both having rea-sonable knowledge of relevant facts, with the amount of the allowable deduction for the contribution of a patent will be the fair market value of the patent interest transferred, and fair market value is always a question of fact.

Thus, the taxpayer claiming a charitable deduction for contrib-uted property has the burden of proving that the amount of the claimed deduction reflects the fair market value of the donated property.138 Three methods are commonly used to value patents and patent rights: the income method, the market method and the cost method. The income method attempts to value a pat-ent based on the present value of the “stream of future economic benefi ts that one can enjoy by owning it.” The market approach relies on an analysis of the pricing at which assets comparable to the property being valued were sold at or around the valuation date. This method is common and has been respected by the courts because it can refl ect clearly what a buyer in the market would be willing to pay for comparable property in an arm’s-length transaction. The cost or adjusted net asset method analyzes value by “aggregating all of the costs necessary to re-create” the property rights being valued.

This method has been seen as useful in valuing charitable con-tributions of unusual property. When applied to the valuation of intellectual property including patent rights, the cost approach may fail to consider important factors such as profi ts from com-mercializing, investment risk and earnings growth potential.

ConclusionThe United States asserts such the jurisdiction of residence over “persons” of the United States, including citizens and residents, domestically organized corpo-rations and partnerships and domestic trusts and estates, and accordingly taxes such persons on their worldwide income. Un-der Code Sec. 865, the source of income from a transfer of intel-lectual 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 li-cense or personal compensation. The purpose of the source rules is to assert the United States’ source jurisdiction to tax income that has suffi cient and reasonable nexus with the United States, using two convenient tests that determine the source of income derivation of the country in which the capital or property is used.

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 Code also imposes a 30-percent gross withholding tax, imposed at the source on the gain within contingent payment sales of intellectual property and paid to nonresident alien individuals and foreign corporations, unless it is effectively connected with the conduct of a U.S. trade or business, in which event the Code imposes special rules on certain transfers of intellectual property by/between related persons, which are subject to special rules that limit the abil-



51

ity of U.S. persons to shift income to foreign entities that are other-wise exempt from U.S. taxation in an effort to avoid current taxation. Capital contributions of intellec-tual property by U.S. persons to foreign corporations in otherwise nonrecognition transactions are taxable as “contingent payment sales” creating “deemed annual royalties” over the useful life of the contributed property, coupled with an abrasive super royalty regime that is applicable to con-tributions of “intangible property,” measured by the yet-tested “com-mensurate with income” standard attributable to the intangible and effectively recharacterizing related party transactions on an arm’s-length basis, creating complex diffi culties regarding the valuation of intellectual property.

The outbound transfer rules of Code Sec. 367 rules enforce the Code’s requirement that the income stream derived from U.S. developed intangibles is taxed to the U.S. parent and limits the abil-ity to transfer income-producing intangibles to foreign subsidiaries in an effort to achieve a deferral of U.S. tax classifi ed as U.S.-source income, making it generally de-sirable to license intangibles to foreign subsidiaries (instead of transferring the intangibles). Roy-alties paid on a license generally will be treated as foreign-source income, with such royalty rate on a license between affi liates, the sale price of goods sold in a transaction between affi liates, the amount paid for services per-formed by one affi liate for another and the compensation paid in any other intercompany transaction all being referred to as transfer prices, the issue of which is the most im-portant area of audit and litigation controversy in the international

tax arena because they are easily identifi ed and potentially involve large amounts of revenue.

Within a multinational enter-prise, costs in relation to services that are rendered within the group or in relation to products and ser-vices that the group developed for the market are increasingly borne jointly by the relevant group com-panies, with the anticipated or relative benefi ts that each of the companies can reasonably derive serving as the key to allocating the overall cost burden, resulting in the progressive evolvement and importance of CCAs, to manage and quantify these relative or an-ticipated benefi ts. Determining the amount of the buy-in (or buy-out) payment involves diffi cult fact and circumstance coupled with valua-tion issues that can directly affect the buy-in or buy-out mechanism contained in cost-sharing agree-ments, with the reward being that such cost-sharing payments that are received by one affi liate from another are generally treated as deductible R&D expenses to such payor affiliate, with the added benefi t of such characterizations of these payments under foreign law not impacting this generally desired result.

The OECD Guidelines classify commercial intangibles as “trade intangibles” and “marketing intan-gibles,” and describe the concept of a “trademark” specifi c 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 exclusivity for the owner of such commercial intangibles via the registration of the trademark, granting it the use and exploitation of the idea or concept, to the exclusion of oth-ers, giving full legitimacy to the

fi scal ownership of the trademark residing with its legal owner, un-less all of the essential rights to a trademark in a jurisdiction are transferred to the licensee, in which case 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.

To the extent that the intangible owner is a U.S. person and the U.S. intangible owner licenses or transfers an intangible to an-other affi liate or otherwise gives another affi liate the use of the in-tangible, the licensee/transferee generally must compensate the U.S. intangible owner. In this instance, U.S. transfer pricing rules govern the amount of compensation that is appropri-ate, and absent comparable uncontrolled transactions that demonstrate that the amount of consideration is arm’s length, Code Sec. 482 may affect the amount of consideration received or imputed in a transfer of intan-gibles. In a period in which 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 prod-ucts and services and thus escape the continuing process of price erosion. Differentiating an intel-lectual property transaction for federal income tax purposes as between a license versus a sale turns 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 classifi cation as a sale.

52

ENDNOTES

1 John J. Cross, III, Taxation of Intellectual Property in Intellectual Transactions, 8 VA. TAX REV. 553 (Winter 1989).

2 See Code Sec. 901(a). U.S. persons are granted a foreign tax credit against their U.S. tax liabil-ity for foreign taxes paid. This credit is subject to a limit under Code Sec. 904, computed by multiplying United States tax liability (before the foreign tax credit) by a ratio of net foreign source (emphasis added) taxable income over worldwide taxable income. Therefore, the ef-fect is that domestic multinational corpora-tions, which typically have excess unusable foreign tax credits (because of the corporate rate reductions under U.S. law since the pas-sage of the 1986 Tax Reform Act (P.L. 99-514)), want to increase foreign source income to raise the Code Sec. 904 limit to enable them to use greater foreign tax credits.

3 Code Sec. 871(a)(1)(D).4 See Reg §1.871-11(c) (1974) (the principles

of Code Sec. 1253, which govern capital gain sale or exchange treatment for transfers of trademarks, trade names and franchises, are inapplicable to determine whether a transfer is a sale or exchange for purposes of Code Sec. 871).

5 See Code Sec. 865(a). The general rule of Code Sec. 865 for source income from the sale of property is subject to exceptions for inventory property under Code Sec. 865(b), depreciable personal property under Code Sec. 865(c), certain intangible property under Code Sec. 865(d) and property sold through fi xed places of business under Code Sec. 865(e).

6 An individual’s “tax home” is “... his regular or principal (if more than one regular) place of business, or, (if none), his regular place of abode in a real and substantial sense,” or, in any event, in the United States, if the individual’s abode is in the United States. Reg. §1.911-2(b) (1985). Second, no U.S. citizen or resident alien shall be treated as a nonresident for purposes of a personal property sale unless such person actually pays a foreign tax equal to at least 10 percent of the tax gain.

7 See Reg. §1.871-11(c). 8 See Code Sec. 1235(a). The term “all sub-

stantial rights to a patent” means “all rights (whether or not then held by the grantor) which are of value at the time the rights to the patent (or an undivided interest therein) are transferred.” Reg. §1.1235-2(b).

9 The current benchmark for a Code Sec. 1235 sale is articulated by D. Kueneman, CA-9, 80-2 USTC ¶9616, 628 F2d 1196, 1200, which held that a geographically limited transfer of a patent is precluded from Code Sec. 1235 treatment. See also C.W. Gilson, 48 TCM 922, Dec. 41,437(M), TC Memo. 1984-447 (a professional inventor’s transfer of design patents qualifi es for Code Sec. 1235 treatment because all substantial rights were transferred for a fl at fee). In J.H. Pickren, CA-5, 67-2 USTC ¶9477, 378 F2d 595, 600, the court deter-mined that an exclusive license of a trade se-cret for a 25-year period failed to constitute

a sale, since a trade secret has an indefi nite life. The court stated, ”... [s]ecret formulas and trade names are suffi ciently akin to patents to warrant the application, by analogy, of the tax law that has been developed relating to the transfer of patent rights, in tax cases involving transfers of secret formulas and trade names.” In Rev. Rul. 55-17, 1955-1 CB 388, the IRS ruled that unpatentable “know-how” can be transferred for consideration and is suffi ciently like a secret process such that payments can be treated as royalty income. See, e.g., J.O. Tomerlin Trust, 87 TC 876, 891-892, Dec. 43,466 (1986), wherein the court held that the transfer of all substantial rights in a trademark for contingent payments constituted a sale for purposes of the personal holding company rules, notwithstanding failure of the transac-tion to qualify as a sale eligible for capital gains treatment under Code Sec. 1253.

10 See Code Secs. 871(a), 881(a) and Code Secs. 1441(a), 1442(a).

11 See Reg. §1.1441-2(a)(3) (“[i]ncome derived from the sale in the United States of property, whether real or personal, is not fi xed or de-terminable annual or periodical income”).

12 Code Secs. 871(b) and 882(a).13 Reg. §1.871-11(d).14 Reg. §1.167(a)(3).15 For copyrights, equal to (1) in the case of an

author, the life of the author, plus 50 years; (2) in the case of work for hire, the shorter of 75 years from publication or 100 years from creation; or (3) in the case of a purchaser, 35 years from the date of purchase.

16 Reg. §1.1441-2(a)(3).17 Code Secs. 871(a)(1)(D), 881(a)(4), and Code

Secs. 871(b) and 882.18 A fi xed place of business is any fi xed facility

through which a foreign person engages in a trade or business, including factories, stores and sales outlets. See Reg. §1.864-7(b)(1).

19 See Reg. §1.864-6(b)(2)(i). An offi ce is a ma-terial factor in the production of intellectual property royalty or sales income if the offi ce actively participates in soliciting, negotiat-ing or performing other activities required to arrange the property transfer or performs signifi cant services incident to the transfer.

Mandating, for example, the attribution of a partnership’s fi xed place of business to each of its partners, and having as its purpose an overriding source rule designed to prevent foreign persons from using the United States as a tax haven by conducting business through fi xed places of business in the United States and manipulating the inventory place of title source rules to generate foreign source income exempt from U.S. tax. The practical effect of the application of this Section is to create United States “source effectively con-nected business income” taxed on a net basis, since income attributable to a domestic fi xed place of business invariably will constitute effectively connected U.S. trade or business income under Code Sec. 864(c).

20 Including intellectial property.

21 I.e., related persons. 22 Code Sec. 367(d)(2)(C).23 Code Secs. 861(a)(4) and 862(a)(4).24 Code Sec. 367(d)(2)(A), as added by the Tax

Reform Act of 1986, and thus, requires that the amount of the deemed annual royalty in covered transactions be “commensurate with the income attributable to the intangible.”

25 Code Sec. 936(h)(3)(B).26 Code Sec. 367(d)(1).27 See Reg. §1.482-2(d).28 Including a Code Sec. 936 (possession)

corporation.29 Code Sec. 936(h) contains rules that apply to

Code Sec. 936 possession corporations (i.e., Puerto Rico, et al.) not covered herein.

30 Code Sec. 1253 is generally applicable to the transfer of a franchise, trademark or trade name, whereas a franchise for this purpose means an agreement that grants the right to distribute, sell or provide goods, services or facilities within a specifi ed area.

31 Code Sec. 1253(a). 32 Code Sec. 1253(b)(2)(A).33 Code Sec. 1253(c).34 J.O. Tomerlin Trust, supra note 9; where the

taxpayer granted an exclusive, perpetual li-cense to use a trademark to produce, sell and distribute certain automotive products, the court stated that Code Sec. 1253 did not create a new standard for defi ning sales and licenses and that pre-Code Sec. 1253 case law governs the issue. Finding the transfer to be a sale and not a license, it reasoned that the transferee’s rights were unlimited in territory and were perpetual, and the taxpayer was bound to transfer legal title to the trademark after the transferee made a specifi ed amount of payments.

35 Dairy Queen “fast food” franchises in each instance, as follows: Dairy Queen of Okla-homa, Inc., CA-10, 58-1 USTC ¶9155, 250 F2d 503; G.R. Gowdeny, Est., CA-4, 62-2 USTC ¶9603, 307 F2d 816; V.H. Moberg, CA-5, 62-2 USTC ¶9662, 305 F2d 800; V.H. Moberg, CA-9, 62-2 USTC ¶9824, 310 F2d 782; F.C. Wernentin, CA-8, 66-1 USTC ¶9140, 354 F2d 757.

36 Like the Tenth and Fourth Circuits, it found the quality control and other rights retained by the transferor to be protective and not proprietary in nature. As to the contingent consideration, the court remanded and subsequently held that such payments were separate and apart from the sales price of the franchise rights and thus were royalties, representing a retained interest in the earn-ings of the franchise.

37 The court disagreed with the Fifth Circuit, however, about the other set of contracts, emphasizing that these did not specify re-strictions on quality control, the transferee’s product line or bookkeeping methods. The transferors under these contracts reserved the right to set such restrictions over time, and the court found such ongoing authority inconsistent with a sale.



53

ENDNOTES38 The court not only reviewed the contract

provisions but also emphasized the trans-feror’s substantive involvement in the busi-ness after the transaction, which included training, technical/business involvement on a weekly basis, control over subfranchisees and other activities.

39 Stokely USA, Inc., 100 TC 439, Dec. 49,052.

40 Nabisco Brands, Inc., 69 TCM 2230, Dec. 50,543(M), TC Memo. 1995-127. In Nabisco Brands, the transferee paid $25 million to the transferor at closing for the Life Savers trademarks and agreed to make additional, annual payments for 10 years. The parties projected that the total annual payments for the 10-year period would be approximately $28.2 million. Actual annual payments for the period totaled approxi-mately $28.7 million. The ultimate amount of each annual payment depended on the transferee’s sale of Life Saver products, but the parties did agree to a fi xed, minimum amount for each payment. For the tax years at issue, approximately 25 percent of each annual payment was contingent and further represented approximately 25 percent of the total consideration, fi xed and contingent, paid by the transferee over the period. The court ruled that these contingent payments were substantial within the meaning of Code Sec. 1253(b)(2) and consequently that the transferor’s retained rights were signifi cant.

41 Resorts International, Inc., CA-5, 75-1 USTC ¶9405, 511 F2d 107.

42 Consolidated Foods Corp., CA-7, 78-1 USTC ¶9180, 569 F2d 436.

43 See, for example, Rev. Rul. 87-63, 1987-2 CB 210; LTR 8823006 (Dec. 23, 1987), LTR 8828027 (Apr. 14, 1988), LTR 8842041 (July 26, 1988), LTR 9032010 (May 10, 1990) and LTR 9852033 (Sept. 29, 1998).

44 Accordingly, Congress prescribed in the statute that the transferor’s retention of any signifi cant right prevents the transfer from being the sale of a capital asset. Accord-ingly, the transferor’s retention of just one right, significant within the meaning of Code Sec. 1253(a) or Code Sec. 1253(b)(2), should serve to classify the arrangement as a license, not a sale.

45 Contingent consideration for this purpose means any amount contingent on the use or productivity of the transferred property if it is part of a series of payments payable at least annually throughout the term of the agree-ment and substantially equal in amount or payable on a fi xed formula.

46 Code Sec. 1253(d)(1), (2) and Code Sec. 197(a), (d)(1)(F).

47 Multinational enterprises.48 Section 6.3 of the OECD Guidelines address

“commercial intangibles. The latter category includes (Section 6.4) “trademarks and trade names that aid in the commercial exploita-tion of a product or service” and “customer lists, distribution channels, and unique

names, symbols, or pictures that have an important promotional value for the prod-uct concerned.” This category could be extended to include “intangibles” such as trademark licenses, studies and concepts for campaigns. With regard to know-how and trade secrets, the OECD Guidelines (Section 6.5) state that these can be either trade intangibles or marketing intangibles.

49 See generally Fred C. de Hosson, Multina-tionals and the Development, Ownership, and Licensing of Trademarks, Trade Names: Part 1, J. INT’L TAX’N, Sept. 2000.

50 In Germany, the law did not provide for a free transfer until 1992. U.S. law stipulates that a trademark must be transferred together with all of its “associated goodwill,” but does not require that the operating business be transferred as well.

51 In the United States, for example, infringe-ment actions can be instituted only by the legal owner, which, in a U.S. context, often may imply that it is desirable that a local group company register the trademark.

52 Reg. §1.482-4(f)(3)(ii)(A), T.D. 8552 (July 1, 1994).

53 See generally Hosson, supra note 49.54 Reg. §1.482-4(f)(3)(ii)(A).55 See Mentz and Carlisle, The Tax Owner-

ship of Intangibles Under the Arm’s Length Principle, 97 TNI 208-16, and Planning the Location of Future Income and Deductions, INTERTAX, 1997/3, at 85.

56 OECD Guidelines, Chapter VI (Special Considerations for Intangible Property), Section D “Marketing activities undertaken by enterprises not owning trademarks or trade names”).

57 Just because unrelated parties would make a division of functions and risks different than related group companies is in itself not a ground to ignore such a division and can only give rise to an investigation into whether adjustments of the prices are required to refl ect that deviating division. In this regard, see also the example in OECD Guidelines, Section 1.41.

58 Levey et al., US Distribution Companies Can Present Diffi cult Transfer Pricing Issues, IN-TERTAX, 1999/3, at 89.

59 See Reichert, Observational Equivalence and the Cheese Example Under the Final Section 482 Transfer Pricing Regulations, TAX MANAGEMENT TRANSFER PRICING REPORT (BNA), Sept. 3, 1997, at 275.

60 An (exclusive) license that can be terminated only by the licensee must be considered extremely long term, if not “perpetual,” and under the circumstances, it will make the licensee the (benefi cial) owner of the trademark in its territory.

61 A balancing act will be required in an exclusive license—where it is easier for a licensee to recover his investments—since in an unrelated situation, the licensor will often insist on a clause that will allow him to terminate the license or remove its exclusive

character, if the licensee is not suffi ciently successful. With respect to promotion and marketing costs, a balance must exist for both parties between rights and obligations. The licensee’s obligations may be spelled out in great detail and require signifi cant spending by him (which is then balanced, for instance, by his low royalty payments), but it may also be, as happens in real life between unrelated parties, that the licensee is completely free to incur these costs or not (which no doubt will be balanced by other terms, e.g., nonexclusive license, high royalty).

62 It is therefore not only relevant whether the licensee bears exceptional costs for the development of the trademark in the terri-tory assigned to it; other relevant aspects of the contractual relations that exist between unrelated parties must be considered as well—for example, whether the owner of the trademark also incurs costs for the development of the global brand name. It is also signifi cant whether the licensee has a contractual obligation to bear promotion and advertising costs up to a certain amount. Unrelated parties also frequently grant full discretionary power to the licensee with regard to the amount of its expenditure on promotion of the licensed trademark.

63 In such situations, the licensee often cannot be regarded as the benefi cial owner of the trademark, as the licensor continues to have an obvious fi nancial interest in the develop-ment of the trademark by the licensee. To protect the positioning of its trademark, it will usually not allow the licensee to apply the trademark entirely at its own discretion or to transfer the license to a third party at its own discretion. On the other hand, it is obvious that the licensee will be prepared to invest substantial amounts in the develop-ment of the trademark for an entirely new group of products only if it acquires consid-erable long-term rights, which may not grant it the benefi cial ownership of the trademark, but defi nitely place it in a stronger position than that of a mere user.

64 See Hosson, supra note 49.65 OECD Guidelines, Chapter VIII, Cost Con-

tribution Arrangements (June 1996). 66 See Hosson, supra note 49.67 Section 8.7 of the OECD Guidelines points

out that while CCAs for R&D of intangible property are perhaps most common, CCAs need not be limited to this activity. They could exist for any joint funding or sharing of costs and risks, for developing or acquir-ing property, or for obtaining services. The example specifi cally named is “the devel-opment of advertising campaigns common to the participants’ markets.” It is not stated anywhere that the less common forms of CCAs are subject to conditions other than those discussed.

68 Supra note 65.69 OECD Guidelines, Chapter VIII, Cost Con-

54

ENDNOTES

tribution Arrangements, Section 8.3.70 OECD Guidelines, Chapter VIII, Cost Con-

tribution Arrangements (June 1996), see Sections 8.4 and 8.6.

71 This pertains in particular to the acquisition of the customers (market share) that the li-censee recruited independently.

72 See generally JOEL D. KUNTZ and ROBERT J. PERONI, U.S. INTERNATIONAL TAXATION (2002); and KEVIN DOLAN, U.S. TAXATION OF INTER-NATIONAL MERGERS, ACQUISITIONS AND JOINT VENTURES (2002).

73 Id.74 See Rev. Rul. 64-56, 1964-1 CB (Part 1)

133.75 See Rev. Rul. 69-156, 1969-1 CB 101.76 Id., supra note 74.77 See Rev. Rul. 71-564, 1971-2 CB 179.78 See LTR 9852033 (Sept. 29, 1998) which

held that the transfer of foreign rights to a trademark constitutes all substantial rights for purposes of Code Sec. 1253, even though the U.S. transferor retains all U.S. rights with respect to the trademark.

79 Thus, the exchange of a copyright on a novel for a copyright on a different novel is a like-kind exchange because the intangibles are the same and the underlying properties are the same. But an exchange of a copyright on a novel for a copyright on a song is not a like-kind exchange, because the underly-ing properties are different. The regulations provide that goodwill or going concern value of a business is not of “like kind” to the goodwill or going concern of another business.

80 In addition, the IRS has held that Code Sec. 482 may be applied in a Code Sec. 1031 like-kind exchange between related parties to impute additional compensation if the value of the intangible right received by the U.S. transferor is not equivalent to the value of the transferred intangible. Furthermore, under the commensurate-with-income standard of Code Sec. 482, additional compensation can be imputed to a U.S. transferor in a related party cross-license in subsequent years following the exchange (a “periodic adjustment”) if it becomes apparent that the transferred intangible is ultimately more valuable than the intangible right received.

81 In circumstances in which Code Sec. 1031 does not apply, taxpayers have generally been assuming that, as a tax accounting matter, it would be inappropriate for the IRS to assert that the U.S. affi liate has an advance royalty upon entering into the cross-license equal to the value of the license right re-ceived in exchange. Instead, the worst result assumed is that, if the IRS were to impute royalty income to a U.S. affi liate under a cross-license, the IRS would be required to grant concurrent deductions for imputed royalties paid to the foreign affi liate equal in amount to the imputed royalty income (on the assumption that the cross-license

is value-for-value), thereby producing a wash.

82 See Rev. Rul. 64-56, 1964-1 CB 133.83 For these purposes, within the meaning of

Code Sec. 936(h)(3)(B).84 The regulations defi ne “intangible property”

to mean “knowledge, rights, documents, and any other intangible item within the meaning of Code Sec. 936(h)(3)(B) that constitutes property for purposes of Code Sec. 332, 351, 354, 355, 356, or 361, as ap-plicable.” Code Sec. 367(d) applies without regard to whether the property will be used for manufacturing or marketing. Further, Code Sec. 367(d) applies without regard to where a foreign corporation intends to use the intangible property, whether inside or outside the United States.

85 Code Sec. 367(d) also does not apply with respect to a copyright, letter, memorandum or literary, musical or artistic composition held by the taxpayer who personally created the property. Further, Code Sec. 367(d) does not apply with respect to a letter, memo-randum or similar item held by a taxpayer for whom the letter or memorandum was produced. Finally, Code Sec. 367(d) does not apply with respect to a copyright, letter, memorandum or literary, musical or artistic composition held by any taxpayer with a basis determined (for purposes of gain on a sale) in whole or part by reference to the basis of the item in the hands of either the taxpayer who produced the item or the tax-payer for whom the item was produced.

86 Operating intangibles for these purposes may include long-term purchase or supply contracts, surveys, studies and customer lists.

87 See Code Sec. 367(d)(2)(A).88 The regulations under Code Sec. 367(d),

however, generally avoid the sale concept and speak instead of a transfer for contingent payments. Moreover, the regulations do not appear to allow the basis of the intangible property to be recovered as in a sale.

89 See KUNTZ & PERONI and DOLAN, supra note 72.

90 Further, it is notable that increasing or reduc-ing the amount of the royalty paid by the foreign subsidiary will not affect the amount of foreign-source income ultimately derived by the U.S. parent, since the royalty payable by the foreign subsidiary is foreign-source income to the U.S. parent.

91 Such three-factor state apportionment meth-odology typically takes into account payroll, property and sales within the state relative to the total of payroll, property and sales of the corporation or, in some instances, of a group of affi liated corporations that compose a unitary business. The obvious arbitrariness of state tax allocation formulae has caused the U.S. federal government traditionally to reject formulary income allocation methods and has caused the international tax com-munity to adopt the arm’s-length standard

as the norm of international tax policy. Increasingly, Congress has indicated dis-satisfaction with the results reached by the IRS under the arm’s-length standard, and some members have called for the use of formulary apportionment in some cases. The arm’s-length standard has been criticized for both theoretical and practical reasons. From a theoretical perspective, it does not take into account the synergies arguably inherent in a multinational enterprise.

92 The fi nal Code Sec. 482 regulations deleted a provision in earlier temporary regulations authorizing the IRS to create formulary safe harbors for small taxpayers. Temporary Reg. §1.482-2T(f)(1). Unless otherwise indicated, all references to the regulations under Code Sec. 482 are to the fi nal Code Sec. 482 regulations (also referred to as the 1994 regulations), which are contained in Reg. §§1.482-0 through 1.482-8.

93 1968 Code Sec. 482 regulations.94 Reg. §1.482-1. 95 Id.96 Id.97 Bausch and Lomb, Inc., 92 TC 525, Dec.

45,547 (1989), aff’d, CA-2, 91-1 USTC ¶50,244, 933 F2d 1084.

98 Id. The resale price method can apply only to the simplest distributing affi liate which does no manufacturing, sells products that are not marketing driven (where marketing intangibles are not important) and does not own manufacturing intangibles used by the manufacturing affi liate.

99 Note: A cost-plus method that uses full ab-sorption costing as the base for measuring the applicable “profi t-to-cost” ratio is, in actuality, a form of comparable profi ts methodology which is discussed in the next section. The cost-plus method is not useful in transfer pricing situations involv-ing a foreign manufacturing subsidiary that owns signifi cant manufacturing intangibles used in the manufacture of the products, as it would not give the foreign subsidiary sufficient profit to reflect the value of its manufacturing intangibles and their contribution to the overall profi t from the product.

Using the court’s analysis in Bausch and Lomb, Inc., the cost-plus method may not be applied by identifying comparable markups of contract manufacturers, i.e., a manufac-turing affi liate that owns no manufacturing intangibles, performs no marketing functions and assumes little or no market risks. Most importantly, neither the resale price method nor the cost-plus method can be used if both parties possess signifi cant manufacturing or marketing intangibles.

100 As in the case of the resale price method and cost-plus methods, it generally should not be used to determine the profi t level of a related party that owns signifi cant intangibles.

101 Asiatic Petroleum Co. (Del.), Ltd., CA-2, 35-2 USTC ¶9547, 79 F2d 234.



55

ENDNOTES

102 See generally, LOWELL, BURGER and BRIGER, U.S. INTERNATIONAL TRANSFER PRICING (2d ed. 2002).

103 Id. 104 Reg. §1.482-3(b)(2)(ii). 105 I.e., sales prices or royalty rates under the

comparable uncontrolled price or transac-tion method.

106 I.e., under the resale price or comparable profi ts method, respectively.

107 Personal opinion as a valuation professional, also, and the term” art over science,” a phrase used by my fi rm in its marketing of our business and tax valuation practice.

108 Arup K. Bose, The Effectiveness of Using Cost Sharing Arrangements as a Mechanism to Avoid Intercompany Transfer Pricing Is-sues with respect to Intellectual Property, 21 VA. TAX REV. 553 (Spring 2002).

109 Ciba-Geigy Corp., 85 TC 172, Dec. 42,271 (1985).

110 U.S. Steel Corp., CA-2, 80-1 USTC ¶9307, 617 F2d 942, rev’g, TC Memo. 1977-140.

111 Perkin-Elmer Corp., 66 TCM 634, Dec. 49,268(M), TC Memo. 1993-414.

112 This case is signifi cant for its analysis of groupings of products and not the aggregate of all intercompany sales in applying the resale price method. Thus, there was a dif-ferent margin for each grouping of products. The court made no adjustment to the prices charged by PE to PEEC on parts purchased by PEEC from PE, owing to the absence of suffi cient information in the record to enable the court to make such an adjustment.

113 Westreco Inc., 64 TCM 849, Dec. 48,527(M), TC Memo. 1992-561.

114 See Reg. §1.482-4(f)(4).115 Nestle Holdings, Inc., CA-2, 98-2 USTC

¶50,606, 152 F3d 83.116 Because the “relief from royalty” methodol-

ogy has been widely used, this case may re-sult in an increase in the value of trademark intangibles in outright transfers subject to Code Sec. 482.

117 DHL Corp., 76 TCM 1122, Dec. 53,015(M), TC Memo. 1998-461, aff’d in part, rev’d in part, CA-9, 2002-1 USTC ¶50,354, 285 F3d 1210.

118 The concept of the “developer” rule is that the party that incurred the costs and risks of developing the intangible should not be re-quired to pay a royalty to use that intangible.

If the costs and risks of development are proven and the identity of the bearer of such costs and risks is established, it is unneces-sary to show the existence of a cost-sharing agreement, as the regulations provide that this rule applies “in the absence of a bona fi de cost sharing arrangement.”

119 Levey, Shapiro, Cunningham, Lemein and Garofalo, DHL: Ninth Circuit Sheds Very Little Light on Bright-Line Test, J. INT’L TAX’N, Oct. 2002.

120 Compaq Computer Corp., 78 TCM 20, Dec. 53,443(M), TC Memo. 1999-220.

121 See generally Reg. §§1.482-1 and 1.482-4 through 1.482-6.

122 Reg. §1.482-7(g)(1).123 Id.124 These include market share, high profi tabil-

ity, lack of regulation, regulated or protected market position, monopoly position or bar-riers to entry, market potential, breadth of appeal, mystique, heritage or longevity, competitive edge, life-cycle status, unique-ness, discount prices, liquidity or illiquidity and ownership control.

125 See Morgan, Buy-In Payments and Market Valuations, 8 TAX MGMT. TRANSFER PRICING REP. 449 (Sept. 15, 1999). See, e.g., Economist Says E-Commerce Firms Using Cost Sharing to Cut Uncertainty, 9 BNA TAX MGMT. TRANS-FER PRICING REP. 70 (May 31, 2000). See J. KAGEL AND A. ROTH, HANDBOOK OF EXPERIMENTAL ECONOMICS, at 446–47 (1995).

126 See A. DAMODARAN, DAMODARAN ON VALU-ATION: SECURITY ANALYSIS FOR INVESTMENT AND CORPORATE FINANCE (1994).

127 Levey, Miesel and Gargofalo, Cost-Sharing Agreements: Buy-In/Buy-Out Payments and the Valuation Problem, J. INT’L TAX’N, Oct. 2000.

128 Id. For example, these intangibles can include software licensing rights, know-how, process technology (R&D-related), long-term contracts, trademarks, trade names, dealer networks and customer lists. The real diffi culties arise, however, when the intangible involves unfi nished (“work-in-process”) R&D. A traditional valuation method of discounting projected cash fl ows (DCF) to calculate value may be highly speculative because there may be no cash fl ows, historical sales or profi ts on which to base projections.

129 That is, a company with valuable product patents that are unused currently, but which could produce signifi cant cash fl ows in the future may therefore be undervalued using traditional valuation techniques.

130 Many companies have several different types of capital issued and are then said to have a differentiated or structured capitalization. The total market value of a company’s is-sued share capital is its market capitaliza-tion. “Capitalization” also refers to the act of converting net retained profi ts or reserves into issued share capital.

131 See Wills, Valuing Technology: Buy-In Payments for Acquisitions, J. GLOBAL TRANSFER PRICING, Feb. 1999, at 31–32. The market capitalization method (if properly used) is generally consistent with the “residual method” used to allocate values to groups of corporate assets, based on seven declining groups or classes of property, ranging chronologi-cally from the tangible to the generically intangible class of property or property right, as used traditionally in Code Sec. 338 acquisitions, as codified in Code Sec. 1060 coupled with Code Sec. 338 and the regulations hereunder.

132 See generally FSA 200023014 (Feb. 9, 2000). A footnote in the FSA states that the market capitalization method will be more useful where the buy-in involves an acquisition of the intangible to be used rather than a short-term license, likely for the reasons noted above. With the high historical price-to-earnings and market-value-to-book multiples seen several years ago, the IRS examiners were attracted to the market capitalization method (and resulting high asset values) despite the many problems with that approach.

133 See Finan, Reliably Determining a Buy-In Payment Under Code Section 482, J. GLOBAL TRANSFER PRICING, Feb. 1999, at 19–20.

134 Reg §1.482-7(h).135 Code Sec. 170, specifically, Code Sec.

170(c)(1) and (2), (b)(1) and (2).136 Rev. Rul. 2003-28, IRB 2003-11, 594. 137 Terri W. Cammarano and Richard F. Riley,

Jr., Contribution of Patents, Valuation Re-mains The Toughest Issue When Donating Patents, J. TAX’N, Nov. 2003.

138 See Rev. Rul. 59-60, 1959-1 CB 237.

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