Corp. A licensed certain technology to G (called Agreement A) in the past. It entered into a closing agreement with the IRS several years ago to treat Agreement A as a license. Later it modified Agreement A in Agreement B, under which Corp. A received an accelerated payment from G. Separately, Corp. A had received from B Agreement C, by which Corp. A acquired certain license rights to Device A, which appears to be the principal patent right in contention. The device manufactures Product, which B will commercialize in the foreign country.
Corp. A claims that the lump sum payment received in the year under audit, and other payments it was to receive in the future under Agreement B with G, were for Corp. A's sale of Device A or Product that it got from B in Agreement C, or for sale of Agreement C. Corp. A reported the lump sum amount received under Agreement B from G as capital gain on the installment method, and not further ordinary income for the license under the original Agreement A license or for a new license of Device A. Therefore, Corp. A says Agreement B sold Device A (or Agreement C) to G on the installment method.
The LB&I memo asserts that (1) an IRS closing agreement as to Agreement A forecloses taxpayer's position as to any sums received in acceleration of Agreement A payments, (2) Corp. A never owned Device A and so could not sell it (Section B of memo), (3) if it could have sold property, in fact it merely franchised it, producing ordinary income (Section C of memo), and (4) if it did own property and did sell it, it improperly applied the installment method (Section D of memo).
As to the installment method, the memo states several errors made by taxpayer, but the most serious is that the installment sale had no fixed maximum payment or fixed period. Rather than prorating the basis recovery as required in the regulations in such a case, the taxpayer estimated the payments to be received and treated that as the fixed maximum amount. The memo states that estimates are never allowed for this purpose.
The memo's argument about the amounts received being franchise payments is based on its argument in Section B that taxpayer did not have any property to sell and did not sell property, specifically the patent for Device A. Assuming taxpayer did own property, the main subissue was whether taxpayer's grant of less than all rights for a country was a sale. The IRS did not dispute the ability of the taxpayer to sell the patent rights for a specific country.
Selling a Patent
First, it is important to know that section 1235 does not apply to this taxpayer. This is the special rule allowing royalty-like payments for a patent to be reported as capital gain, but it applies only to individuals and thus does not apply to the ILM. If it did apply, it would not allow sale of a geographical slice of the patent to produce a capital gain, at least according to Reg. section 1.1235-2.
Rather, the ILM deals with the confusingly similarly numbered section 1253. It directs that a franchise does not produce capital gain and defines a franchise as the right to provide goods or services in a geographical area. Thus it would seem that taxpayer loses under section 1253 too. But does the taxpayer lose if taxpayer proves it did not merely grant rights to some activities in a geographical area, but rather transferred a vertical slice of all patent rights for a geographical area? The ILM asserts that the taxpayer did not transfer all rights for a geographical area as a matter of fact.
As to the ability to sell a territorial right to a patent, the Tax Court decided this issue in 1964 adverse to the IRS and the IRS nonacquiesced. William S. Rouverol, 42 TC 186 (1964) nonacq. Four days after the Rouverol opinion was issued the Treasury issued proposed Reg. 1.1235-2(d) changing the definition of substantial part of a patent to preclude a geographical slice. T.D. 6852. Presumably Rouverol represents good law outside the section 1235 context, although it was a section 1235 case. Cf. Rev. Rul. 78-328, 1978-2 C.B. 215.
Kueneman v. CIR, 68 TC 609 (1977) recites that the Tax Court previously rejected the regulation as to geographic slices, and it was in turn overruled by the Seventh Circuit and the rationale of its ruling was rejected by the Sixth and Ninth Circuits. So Kueneman set about to reconsider the issue. The court concluded that if the retained geographical rights were valuable, then section 1235 did not apply. The taxpayer did not assert rights outside section 1235. The ILM raises the issue outside section 1235; it has never been decided by the Supreme Court. But, as noted, the IRS did not contest in the ILM the ability of a true sale of a territorial slice to occur.
The ILM states a six factor test to determine if a patent or similar know how has been sold. It does not claim that the six factor test pre-existed, but rather engages in extensive analysis of certain authorities to support the factors.
The first factor is obvious enough: an intent to sell property. The principal cite is Kronner v. United States, 110 F. Supp. 730 (Ct. Cl. 1953). The second factor is ownership of the property. The third factor is applicable tax doctrines on income acceleration. The fourth and fifth factors are the core of the test: whether the agreement is a license or a sale of property. The sixth factor relates to the fourth and fifth: whether the taxpayer retains significant rights.
As to the fourth and fifth factors the memo first described the patent law rules on sale versus license in Supreme Court opinions from 1891 and 1923 and then relied again on the Kronner opinion to tie tax treatment to the patent law rules. This is a most peculiar line of analysis and signals that the IRS realizes it has a hard argument to make.
The Supreme Court decisions simply conclude that the transfer of less than all of the rights in a U.S. patent do not invest the transferee with the rights of a patent owner. The first of the Supreme Court decisions cited, Waterman v. Mackenzie, 138 U.S. 252 (1891), involved the Waterman fountain pens. Waterman sued to prevent an infringement. The Court dismissed the suit because Waterman did not own the patent because Waterman had borrowed money and conveyed the patent as security for the loan and only the lender could enforce the infringement claim.
The reasoning of the Supreme Court in Waterman is not entirely or even primarily based on federal patent law. Rather it begins with the proposition based largely on cites to state and English cases that a mortgage conveys the ownership of the property. Then it observes that a mortgage of a patent right is peculiar in that the patent right is a wasting asset, which means that if it is to have value to the lender, the lender must have the right to collect royalties and protect the patent by suits against infringers. It then states that Congress could not have intended otherwise in setting up the patent registration process. Therefore, the lender and not the borrower was the proper party to sue the infringer. The Waterman view of proper parties has been superceded by Federal Rule of Civil Procedure 19, and replaced by different considerations of joinder. See E-Z Bowz, L.L.C. v. Prof'l Prod. Research Co., 2003 U.S. Dist. LEXIS 15257 (S.D.N.Y. Sept. 5, 2003).
The next Supreme Court decision cited, Crown Die & Tool Co. v. Nye Tool & Machine Works, 261 U.S. 24 (1923), is another decision denying a right to sue to protect a patent. The plaintiff had received from the patentee a contract entitling it to sue for infringements of the patent. The Court ruled that the assignee of that right did not own the patent and so was not the proper party to sue, without joining the patent owner. The opinion was based on the view of the Court that the mere right to sue did not comprise the entire set of rights that were the patent. Because the Court ruled that the United States granted the patent and it was not a common law right, the law defining the patent rights could only be federal law, the law related to patents.
As to Kronner, the Claims Court opinion that supposedly ties the tax determination of patent sale to the patent determination as evidenced by the old pleading cases discussed above, it has been cited once by the Supreme Court. United States v. Zacks, 375 U.S. 59 (1963) (not cited in the ILM) identified Kronner as one of the rulings that disagreed with the IRS's position between 1950 and 1954 (Kronner involved years 1943-1947). Zacks said the issue was decided against the IRS in the 1954 Code: section 1235 providing that transfer of all substantial rights produced capital gains even if the consideration was paid periodically or contingent on use.
The sale in Kronner actually occurred in 1921. The inventor had conveyed all of the rights to a clutch to Borg-Warner for the life of the patent. The opinion recited the two Supreme Court decisions and other authorities for the rule that if less than all of the rights to a patent are conveyed then the conveyance is probably a license. Because all of the rights were conveyed the conveyance was a sale.
There was no dispute between the parties as to the law governing a sale and a license; rather the dispute was over the facts and the opinion contained extended discussion of the contract.
The focus of the ILM argument is that tax law should follow patent law and patent law does not allow the assignment of less than all of a patent; anything less is a mere license. 35 USC section 261 governs ownership and assignment of patents and it authorizes assignment of patent rights for specified parts of the United States. Moreover, the third Supreme Court opinion that the ILM cites does the same. It stated that patents could be assigned "…or, third, to the exclusive right under the patent within and throughout a specified territory. Rev. Stat. 4898." Pope Mfg. Co. v. Gormully & Jeffery Mfg. Co., 144 U.S. 248.Therefore, even though the Treasury took the position in the section 1235 regulations that "substantially all" patent rights could not be a geographical slice, in the ILM the IRS did not rely on that approach.
The IRS really does not want a geographical slice of a patent to be sold at a capital gain. However, it can't get around the patent statute and Supreme Court cases that say that a geographical slice can be sold. Therefore, as in this ILM, the IRS works very hard to show that the taxpayer held back some other claim or right of the patent in the geographical area it says is franchised.
By tying the tax treatment to the patent treatment the IRS is going down a road it usually tries to avoid, or at least the Supreme Court usually tries to avoid. The tax law is usually sui generis, as for example in the area of assignment of income. The IRS may come to regret the patent law linkage.