A New York State Administrative Law Judge has held that patent license fees charged for the use of a taxpayer’s patents covering methods and apparatus used to perform laser corneal surgery are not subject to sales tax. Matter of AMO USA, Inc., DTA No. 824550 (N.Y.S. Div. of Tax App., June 19, 2014).  The decision rejects multiple arguments raised by the Department of Taxation and Finance to support taxability, most of which were based on the contention that the fees were in actuality part of the sales price for the laser equipment itself.

Facts.  AMO USA, Inc. (“AMO”) is engaged in the development, manufacture, and distribution of surgical procedures and technology for use in laser-assisted corneal surgery.  Since 1985 and through the period in issue (March 1, 2004 through November 30, 2006), AMO applied for and received 56 United States patents related to performing laser corneal surgery.  It granted a nonexclusive license to 65 U.S. patents to perform the surgery (although six of those patents had expired midway through the audit period). 

AMO sold excimer lasers used for laser surgery, and it  collected New York sales tax on its nonexempt sales of those lasers in New York.  When AMO sold an excimer laser directly to a physician or hospital, it also entered into a nonexclusive patent license agreement with that purchaser-operator.  The license gave the purchaser-operator permission to perform the patented and FDA-approved corneal surgery.  In exchange,  the purchaser-operator agreed to pay AMO a per-procedure license fee of either $100 or $235, depending on the procedure.  The fees were included as a separately identifiable line item on AMO’s invoices.  AMO did not collect sales tax on the procedure license fees.

AMO also sold plastic key cards that were required to be inserted in the laser in order to perform the surgical procedures.  AMO did collect sales tax on the charges for the key cards.  AMO also entered into license agreements with competitors, allowing those companies to manufacture and distribute lasers covered by its patents, and allowing those companies to license to surgeons the right to perform the patented procedures, in exchange for a license fee.

Sales tax is imposed on the sale of tangible personal property, but not on intangible personal property.  The sales tax law and regulations do not specifically define “patents” as intangible property, although they are so defined under Article 9-A.

Following an audit of AMO’s sales tax returns, the Department assessed sales tax on the procedure license fees.  At the administrative hearing, AMO took the position that patent license fees were for a separately identified and invoiced intangible right that was not subject to sales tax.

The Department made several arguments in support of taxability.  First, it called into question the validity of the fee itself, since the charges did not account for the expiration of six patents.  The Department claimed that the fee was merely an additional cost for the lasers that was “backloaded” in the transaction (“[a] ploy to increase business”).  It also claimed that the arrangement was “an integrated or step transaction” in which both the patent license and the key card were merely part of the taxable sale of the excimer laser system.

Decision.  The ALJ held that both the form and substance of the transactions evidenced that the patent license fee was a payment for a valuable and bona fide intangible right, and therefore was not subject to sales tax.  The ALJ found that the laser sales agreement, key card agreement, and patent license agreement “clearly established both the form and substance of the transaction,” and that AMO did not convey its patent rights when it sold the laser system.

The ALJ rejected as unsupported by the record the Department’s claim that the sale of the laser and key card included an implied right to use it, and that the fee was merely an additional cost of the laser system separately stated to  avoid sales tax.  As for the Department’s argument that the expiration of six of AMO’s 65 patents, without any reduction of the license fee, showed that the fees had no rational basis, the ALJ noted that the expired patents were the oldest and least technologically advanced.  He also rejected the Department’s claim that the fee was a “pricing scheme” by which AMO “backloaded” part of the cost of the lasers.

As the patents were intellectual property of considerable value, the fees for the patents also were not an expense item  of AMO passed through to purchasers of the lasers.  The ALJ distinguished the case from Penfold v. State Tax Commission, 114 A.D.2d 696 (3d Dep’t 1985), where the Third Department upheld the imposition of sales tax on “dumping fees” for the taxable service of trash removal, finding that the dumping of trash was merely an expense of the company performing the trash removal.  In contrast, the patent license fees were made pursuant to a separate written agreement and were designed to protect a valuable intangible right.  In Advisory Opinion, TSB-A-11(32)S (N.Y.S. Dep’t of Taxation & Fin., Dec. 7, 2011), the Department had ruled that a seller of laser surgery equipment that also charged equipment purchasers a per-use fee was presumed to be making taxable sales with respect to those fees.  The ALJ distinguished the Advisory Opinion on the grounds that it involved a fee by a taxpayer that did not own the patent, so that the fee was merely an expense that was being passed along to purchasers of the laser equipment. The ALJ’s discussion of two other legal arguments by the Department is noteworthy.  The Department claimed that AMO was selling an “indivisible bundled transaction” under which the patent license fee could not be broken out.  The ALJ pointed out that under the bundled transaction rule, where a single invoice charge includes both taxable and nontaxable components, the entire charge is subject to sales tax.  Here, however, the taxable and nontaxable portions were separately purchased, with separately identified charges that were shown to be reasonable, and thus the rule was inapplicable.

The ALJ also addressed the Department’s contention that the sale of lasers was an “integrated transaction” based on a “step transaction” analysis, and that the license fee could not be broken out.  The ALJ referred to the Department’s “novel application [of the step transaction doctrine] to the sales transaction herein [as] ill-fitting and tenuous.”  Even if the step transaction doctrine were applied, however, the ALJ concluded that the individual step of having customers purchase patent licenses “was an intended end result in and of itself.”

Additional Insights

While the Department appears to have viewed the procedure license fee as nothing more than part of the sales price of AMO’s taxable sale of the lasers themselves, the ALJ correctly concluded that the patents were bona fide and valuable intangible rights that were separately licensed between unrelated parties for a separate charge.  Moreover, the license fee was sometimes charged even where AMO did not sell the lasers.  Thus, there was both form and substance to the licensing arrangements, and the Department’s resort to various creative arguments to tax those arrangements was unavailing.