The parties to licenses of technology should consider tax issues with such licenses. The following is a summary of some of the tax implications that may arise with regard to technology licenses.
Withholding Taxes. Where a license crosses an international border, withholding taxes may apply to any royalties payable. Under the Internal Revenue Code, in general, royalties payable by U.S. persons to a foreign resident will be subject to U.S. federal income tax withholding at a 30% rate. However, an income tax treaty between the United States and the foreign resident’s jurisdiction may reduce, or even eliminate, the withholding tax rate. If you are a recipient of royalties subject to withholding taxes, you should consider: (a) whether you qualify for a reduced rate of withholding under an income tax treaty; and (b) whether the payor of the royalties should “gross‐up” the royalty payments to cover any withholding taxes. Under a “gross‐up,” the recipient will receive the full amount of the royalty after withholding of any applicable taxes. For example, assume a recipient is entitled to a royalty of a $100 and the withholding tax rate is 30%. Under a “gross‐up,” the payor would pay a gross royalty of approximately $143. The payor would withhold $43 for the 30% withholding taxes such that the recipient would receive $100 after withholding.
Is it a Royalty? Sometimes, a royalty is structured as a share of future profits from the use of the technology, intellectual property, etc. For example, the recipient may receive a 20% share of profits for the next five or ten years. While structured as a royalty, such an arrangement may be treated as a “continuing interest” in the business by the licensor for U.S. federal income tax purposes. The tax treatment of a “continuing interest” may be very different than a royalty. For example, if the recipient is foreign, it may now realize “effectively connected income” from the United States which may result in significant adverse U.S. federal income tax consequences to the recipient. Also, while a royalty generally is treated as “ordinary income,” income from a continuing interest may be treated as capital gains. In general, there are no hard and fast rules for determining when a share of profits will be treated as a royalty or continuing interest for U.S. federal income tax purposes and it may be possible to structure a transaction in a manner to obtain the desired result.
License as Property. On occasion, a party wishes to transfer a non‐exclusive license to a corporation or partnership in exchange for an interest in that corporation or partnership. In order for such an exchange to be tax‐free, among other things, the license must be treated as “property” for U.S. federal income tax purposes. However, the IRS maintains that a non‐ exclusive license is not property for this purpose. Nonetheless, the courts have been far more generous in such determinations. Accordingly, a taxpayer transferring such a license may be comfortable treating the license as property, despite the IRS’ position.
The following are just some tax issues that may arise in tech transactions, such as licenses. The parties to such a transaction should consult with competent tax advisors to ensure that desired tax outcomes are obtained and no one falls into a trap for the unwary.