Definition of Intangible Property
Categories of Intangible Property
In Income Tax Regulations section
1.482-4(b) the final section 482 regulations[fn.
1] define an intangible as an asset with substantial
value "independent of the services of any individual," and
as comprising any of the following six categories:
- Patents, inventions, formulae, processes, designs,
patterns or know-how,
- Copyrights and literary, musical or artistic
compositions,
- Trademarks, trade names or brand names,
- Franchises, licenses or contracts,
- Methods, programs, systems, procedures, campaigns,
surveys, studies, forecasts, estimates, customer lists
or technical data and
- Other "similar" items. An item is considered
"similar" if it derives its value not from "physical
attributes," but from its "intellectual content or other
intangible properties."
The final regulation definition of
intangible property does not include language from the
temporary regulation[fn. 2] definition
which required intangible property to be "commercially
transferable." See Income Tax Regs. § 1.482-4T(b) and
Merck & Co. Inc. v. United States, 24 Cl. Ct. 73
(1991), 91-2 U.S.T.C. (CCH) ¶ 50456 at 89,732-33
(parent-subsidiary "organizational structure" held not to
qualify as intangible property under 1968 regulations).
Despite the omission of this language, Merck probably
still has value as precedent as the final regulation
definition of intangible property does not materially differ
from the 1968 regulation definition.
Transfers of "Know-How" in Connection with the
Performance of Services
A reoccurring transfer pricing
issue concerns whether intangibles such as "know-how" may be
transferred in connection with the performance of services.
This issue may arise where technical personnel employed by a
U.S. company provide technical assistance to a foreign
related entity. As noted above, Income Tax Regulations
section 1.482-4(b) defines an intangible as an asset that
has "substantial value independent of the services of any
individual." This language indicates that an employee using
"know-how" in providing services to a related party does not
necessarily thereby transfer an intangible. In such a case,
the "know-how" may have little value to the related party
apart from the services.
However, if the employee reduces
the knowledge to writing in the form of designs, formulas,
processes or other written forms, the Internal Revenue
Service (the "Service" or "IRS") might argue that a transfer
of an intangible has occurred. Under such facts, the
employee arguably has transferred an intangible even though
services were also performed. Otherwise, such intangible
rights could be transferred without arm's-length
compensation simply by transmitting the intangibles via the
memory of an employee.
The Treasury Department Technical
Explanation of the United States-Australia Income Tax Treaty
provides some guidance on this point. The explanation of
Article 12, paragraph 4, states that the term "royalty"
implies a "property right as distinguished from personal
services." The explanation includes the example of an
engineer or architect who prepares a design for a customer
and is therefore treated as performing personal services,
rather than transferring intangibles. However, the
explanation includes a counter example of an engineer or
architect supplying pre-existing designs or blueprints.
Under such circumstances, the engineer or architect is
described as furnishing knowledge or information and
therefore transferring an intangible. Thus, the Technical
Explanation implies that no transfer would result if the
engineer or architect had developed a new design or
blueprint as opposed to simply supplying a pre-existing
design or blueprint from memory or otherwise.
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The Treasury Department Technical
Explanation of the United States Model Income Tax
Convention, at Article 12, paragraph 2, provides similar
guidance in its description of the term "royalties":
"The term 'royalties' also does not include payments for
professional services (such as architectural,
engineering, legal, managerial, medical, software,
development services). For example, income from the
design of a refinery by an engineer (even if the
engineer employed know-how in the process of rendering
the design) or the production of a legal brief by a
lawyer is not income from the transfer of know-how
taxable under Article 12, but is income from services
taxable under either Article 14 (Independent Personal
Services) or Article 15 (Dependent Personal Services) .
. . "
Interestingly, the final
regulations on the classification of transactions involving
computer software provide that the provision of information
with respect to the transfer of a computer program will be
treated as the transfer of "know-how" only if the
information is, among other requirements, (i) furnished
under conditions preventing unauthorized disclosure,
specifically contracted by the parties and (ii) "subject to
trade secret protection." Income Tax Regs. § 1.861-18(e).
See also Income Tax Regs. § 1.861-18(h), Example 16.
Public statements from Service
officials indicate that the transfer of "know-how" through
the provision of services may be discussed in the revisions,
now underway, to the services regulations.
Coordination with Tangible Property Rules
Embedded Intangibles
Income Tax Regulations section
1.482-3(f) provides that ordinarily the transfer of tangible
property with an "embedded" intangible such as a trademark
will be considered a transfer of only tangible property if
the purchaser does not receive the right to exploit the
embedded intangible other than through reselling the
tangible property. For example, where a controlled
distributor distributes a product bearing a trademark owned
by a related party, the transaction will be treated as a
transfer of tangible property rather than as including a
separate transfer of intangible property. Therefore, a
royalty or other payment for the intangible will not be
required. However, the regulation states that the embedded
intangible must be accounted for in determining
comparability of controlled and uncontrolled transactions.
Exploited Embedded Intangibles
Income Tax Regulations section
1.482-3(f) also provides that where a controlled purchaser
receives the right to exploit an embedded intangible,
arm's-length consideration must be determined for both the
tangible and intangible property. The regulation includes an
example of a controlled purchaser of a machine receiving the
right to use a process incorporated in the machine to
manufacture a product. The regulation concludes that the
purchaser is not simply purchasing the machine, but is also
exploiting the embedded intangible and thus arm's-length
consideration must be determined separately for the embedded
intangible. Thus, a royalty or other payment for the
intangible may be required, and the controlled purchaser
will presumably be treated as owning the embedded intangible
for purposes of determining its arm's-length income.
Intangible Property Methods
The final regulations list four
methods for determining arm's-length consideration for
transfers of intangible property:
- The comparable uncontrolled transaction ("CUT")
method,
- The comparable profits methods ("CPM"),
- The profit split method and
- Unspecified methods.
Income Tax Regulations section 1.482-4(a) provides that
each of the above methods must be applied in accordance with
all of the provisions of Income Tax Regulations section
1.482-1, including the "best method" rule.
Comparable Uncontrolled Transaction ("CUT") Method
The comparable uncontrolled
transaction ("CUT") method of Income Tax Regulations section
1.482-4(c) determines whether the amount charged for a
controlled transfer of intangible property is arm's length
by reference to the amount charged in a comparable
uncontrolled transaction.
Reliability of CUT Method.
Income Tax Regulations section 1.482-4(c)(2)(ii) provides
that if an uncontrolled transaction involves the transfer of
the same intangible under the "same", or "substantially the
same", circumstances as the controlled transaction, the
results derived from applying the CUT method will generally
be the most reliable measure of an arm's-length result for
the controlled transfer of an intangible. The circumstances
of the controlled and uncontrolled transactions will be
considered "substantially the same" if there are at most
only minor differences that have a definite and reasonable
ascertainable effect on the amount charged and for which
appropriate adjustments are made. If such uncontrolled
transactions cannot be identified, uncontrolled transactions
that involve the transfer of "comparable" intangibles under
"comparable" circumstances may be used in applying the CUT
method, but the reliability of the analysis will be reduced.
This "comparable" standard allows more frequent use of the
CUT method, which otherwise would rarely be applicable.
CUT Comparability Requirements.
Income Tax Regulations section 1.482-4(c)(2)(iii)(A)
provides that the degree of comparability between controlled
and uncontrolled transactions is determined by applying the
comparability provisions of Income Tax Regulations section
1.482-1(d). In addition, the regulation states that because
differences in contractual terms, or the economic conditions
in which transactions take place, could materially affect
the amount charged, comparability under the CUT method also
depends on similarity with respect to those factors.
Under Income Tax Regulations
section 1.482-4(c)(2)(iii)(B)(1), the intangible property
involved in the controlled and uncontrolled transactions
must be used in connection with similar products within the
same general industry or market having similar "profit
potential." The regulations provide that the profit
potential of an intangible is most reliably measured by
calculating the net present value of the benefits to be
realized. This calculation is based on prospective profits
to be realized or costs to be saved through the use or
subsequent transfer of the intangible, considering the
capital investment and start-up expenses required, the risks
to be assumed, and other relevant considerations. The need
to reliably measure profit potential increases in relation
to both the total amount of potential profits and the
potential rate of return on investment necessary to exploit
the intangible. If the information necessary to directly
calculate net present value of the benefits to be realized
is unavailable, and the need to reliably measure profit
potential is reduced because the potential profits are
relatively small in terms of total amount and rate of
return, comparison of profit potential may instead be based
upon the following "comparable circumstances" factors listed
in Income Tax Regulations section 1.482-(c)(2)(iii)(B)(2):
- The terms of the transfer, including the
exploitation rights granted in the intangible, the
exclusive or nonexclusive character of any rights
granted, any restrictions on use or any limitation on
the geographic area in which the rights may be
exploited,
- The stage of development of the intangible
(including, where appropriate, necessary governmental
approvals, authorizations or licenses) in the market in
which the intangible is to be used,
- Rights to receive updates, revisions or
modifications of the intangible,
- The uniqueness of the property and the period for
which it remains unique, including the degree and
duration of protection afforded to the property under
the laws of the relevant countries,
- The duration of the contract or other agreement, and
any termination or renegotiation rights,
- Any economic and product liability risks to be
assumed by the transferee,
- The existence and extent of any collateral
transactions or ongoing business relationships between
the transferee and transferor and
- The functions to be performed by the transferor and
transferee, including any ancillary or subsidiary
services.
Although all of the factors described in Income Tax
Regulations section 1.482-1(d)(3) must be considered in
evaluating the comparability of the circumstances of the
controlled transactions, the foregoing factors may be
"particularly relevant" to the CUT method.
Income Tax Regulations section
1.482-4(c)(4) discusses four examples of the application of
the intangible property comparability provisions.
Example 1 involves a U.S.
pharmaceutical company that develops a disease-fighting drug
and licenses the drug under identical terms to its foreign
subsidiary and to an unrelated company in a neighboring
country. The neighboring country is described as similar to
the subsidiary's country in terms of population, per capita
income and the incidence of the disease. The drug is
expected to sell in similar quantities and prices in both
countries and the costs of producing and marketing the drug
is expected to be approximately the same in both countries.
The example concludes that the uncontrolled license is a
reliable measure of an arm's-length royalty rate. Thus, this
is an example of the theoretical application of the CUT
method. See also Income Tax Regs. § 1.482-8, Example 7,
which is the same example.
Example 2 involves the same facts
except the incidence of the disease is "much higher" in the
neighboring country. The example concludes that the "profit
potential" is much higher in the neighboring country and
thus the unrelated license is unlikely to provide a reliable
measure of an arm's-length result.
Example 3 illustrates the use of
an arm's-length range to determine a royalty for the
transfer of intangible property. Example 3 involves a
foreign company that for a 3 percent royalty licenses to its
U.S. subsidiary the exclusive North American rights to use a
patented heat exchanger used to cool industrial equipment.
The foreign parent does not license the heat exchanger to
unrelated parties. The district director uses an SEC
database to identify 40 uncontrolled license agreements,
which yield 15 agreements the district director finds to
involve similar rights and a "similar level of technical
sophistication." From these 15 agreements the district
director computes an interquartile range of from 1.25 to 2.5
percent and makes an adjustment reducing the 3 percent
royalty to 2 percent, the median of the range. This example
is significant as typically the CUT method will not apply,
but taxpayers may be able to locate unrelated license
agreements of "similar levels of sophistication" from SEC or
other databases.
Example 4 involves a U.S.
pharmaceutical company licensing a new anti-headache drug to
its European subsidiary. The U.S. company previously
licensed a different anti-headache drug to unrelated
European licensees, but that drug produced some side effects
and was similar to other drugs on the market. The example
concludes that the new drug has greater profit potential and
thus the previous license is not a comparable uncontrolled
transaction.
The Comparable Profits Method ("CPM")
Under the Comparable Profits
Method ("CPM") of Income Tax Regulations section 1.482-5, an
arm's-length result is determined by comparing the operating
profit of the "tested" party with the operating profit of an
uncontrolled party involved in comparable transactions.
Thus, the CPM looks at profits rather than transactions.
Generally, the tested party's profit is measured in terms of
"profit-level indicators" such as rate of return on capital
employed or the ratio of gross profit to operating expenses.
The regulations state that the tested party should normally
be the "least complex" of the controlled entities. Income
Tax Regs. § 1.482-5(b)(2).
The final regulations state that
the CPM is less dependent on close functional comparability
than the cost plus or resale price methods because operating
profit is used rather than gross profit. The final
regulations also state that the CPM should generally be less
sensitive to product comparability differences than the
resale price or cost plus methods, but may be more sensitive
to differences such as business structure or management
effectiveness, which may impact operating profit to a
greater extent than gross profit. Income Tax Regs. §
1.482-5(c)(2)(ii), (iii). This language may be used to
support use of the CPM where the Service is attempting to
use a gross margin method such as the resale price method,
despite significant functional differences between the
controlled and uncontrolled transactions.
The inclusion of the CPM in the
regulations reflects the increasing use of that method by
the Service and, to a lesser extent, by the courts in
resolving transfer pricing disputes. See, e.g., Westreco,
Inc. v. Commissioner, T.C. Memo. 1992-561, 64 TCM (CCH)
849, 862-64 (1992) where the court relied in part on a
CPM-type method in concluding that no adjustment to the
taxpayer's transfer prices was required.
The Profit Split Method
The final regulations provide in
Income Tax Regulations section 1.482-6 for two profit split
methods: The "comparable" profit split method and the
"residual" profit split method.
Under the comparable profit split
method, the profit split used in comparable uncontrolled
transactions is applied to the controlled transactions.
Because of the difficulty in obtaining uncontrolled profit
split information, including information needed for
consistent accounting treatment, it is likely that the
comparable profit split method will seldom be a viable
approach. Income Tax Regs. § 1.482-6(c)(2).
Under the residual profit split
method, a market return is assigned to routine functions,
with the residual profit divided based upon the controlled
parties' relative contribution of the intangible property
generating the residual profit. The final regulations, under
certain circumstances, allow the use of the capitalized cost
of intangibles to determine the relative value of
intangibles. Income Tax Regs. § 1.482-6(c)(3).
The final regulations state that
if the data and assumptions are significantly more reliable
with respect to one of the controlled parties, a method
other than the profit split method which focuses on the
results of that party, may yield more reliable results.
Thus, the regulations prescribe use of the CPM rather than
the profit split method where, as may often occur, the data
and assumptions are significantly more reliable as to one of
the controlled parties. See, e.g., Income Tax Regs. §
1.482-8, Example 9, where the CPM is used in lieu of the
profit split method.
Courts generally have used the
profit split method to test the reasonableness of transfer
pricing, rather than as an allocation methodology. See,
e.g., National Semiconductor v. Commissioner, T.C. Memo.
1994-195, 67 TCM (CCH) 2849, 2865-66 (1994) and PPG
Industries v. Commissioner, 55 T.C. 928, 997 (1970).
Compare Eli Lilly & Co. v. Commissioner, 84 T.C. 996
(1985), aff'd in part, rev'd in part, and rem'd, 856
F.2d 855 (7th Cir. 1988) (taxpayer used a profit split
method which was adjusted by the court).
Unspecified Methods
Income Tax Regulations section
1.482-4(d)(1) states that consistent with the specified
methods, an unspecified method should take into account the
general principle that uncontrolled taxpayers evaluate the
terms of a transaction by considering the realistic
alternatives to that transaction, and only enter into a
particular transaction if none of the alternatives is
preferable to it. The regulation further states that, to the
extent that an unspecified method relies on internal data
rather than uncontrolled comparables, its reliability will
be reduced.
Income Tax Regulations section
1.482-4(d)(2) contains an example of a U.S. company that
licenses an industrial adhesive process to its foreign
subsidiary for a royalty of $100 per ton of adhesive
produced. The example concludes that the royalty is not
arm's length because "reasonably reliable estimates"
indicate that the U.S. company could have manufactured the
adhesive and earned a $250 per ton profit. Apart from
problems relating to projecting profits, this "make or buy"
analysis is inconsistent with the case law. Compare
Bausch & Lomb, Inc. v. Commissioner, 92 T.C. 525, 593
(1989), aff'd, 933 F.2d 1084 (2d Cir. 1991) (U.S.
parent corporation's ability to manufacture contact lens at
$1.50 per lens held not to impair reliability of CUP
transactions supporting a $7.50 per lens controlled sales
price to Irish subsidiary).
"Unspecified methods" for
intangible transfers could include profit split methods
other than the two methods prescribed in Income Tax
Regulations section 1.482-6, e.g., a split computed
using a rate of return on asset analysis.
Periodic Adjustments
Adopting the "commensurate with
income" language added to section 482 by the Tax Reform Act
of 1986, the final regulations state that where an
intangible is transferred under an arrangement covering more
than one year, each year will be examined separately "to
ensure that it is commensurate with the income attributable
to the intangible." Income Tax Regs. § 1.482-4(f)(2)(i).
The regulations state that an adjustment may be made for a
later year, even though the initial year's consideration is
arm's length. The regulations further state that periodic
adjustments "shall be consistent with the arm's-length
standard." Id. Query, whether taxpayers may still
contend, relying on the "arm's-length standard" language,
that if uncontrolled parties would have bargained based upon
projected profits, then later-year actual profits should not
be taken into account in determining an arm's-length
royalty. Cf. R.T. French Co. v. Commissioner, 60 T.C.
836, 852 (1973).
There is little experience to date
where the Service has applied the periodic adjustment
provision. Compare Bausch & Lomb v. Commissioner, 92
T.C. 523 (1989) where the Court's determinations may have
been different under the final regulations. In determining
the arm's-length royalty, the Court presumably would have
considered later-year actual, rather than projected profits.
Because actual profits exceeded projected profits, the Court
would have calculated a greater royalty, assuming the same
methodology was employed. Id. at 608-11.
Exceptions to Periodic Adjustment Requirement
The final regulations include five
exceptions to the periodic adjustment rule which differ
depending upon whether the CUT method is used. Several of
the exceptions apply only if a number of preconditions
exist. The regulation provisions prescribing the exceptions,
which are summarized below, should be carefully reviewed to
determine their application to particular fact situations.
The first exception applies where
the CUT method is used to determine the arm's-length price
and (i) the CUT involves the "same" intangible transferred
under "substantially the same circumstances" and (ii) the
first-year compensation for the controlled transaction is
arm's length as measured by the uncontrolled transaction.
Income Tax Regs. § 1.482-(4)(f)(2)(ii)(A).
The second exception applies where
the CUT method is used to determine the arm's-length price,
the CUT involves a "comparable" intangible transferred under
"comparable circumstances," and:
- The controlled taxpayers enter into a written
agreement providing for arm's-length consideration for
the first taxable year for which substantial periodic
consideration is required;
- There is a written agreement setting forth the terms
of the comparable uncontrolled transaction that does not
contain any provisions that would permit a change in the
amount of periodic consideration under circumstances
comparable to those of the controlled transaction;
- The controlled agreement is substantially similar to
the uncontrolled agreement with respect to the time
period for which it is effective;
- The controlled agreement limits use of the
intangible to a specified field or purpose in a manner
consistent with industry practice;
- There are no substantial changes in functions
performed by the controlled transferee after the
controlled agreement is executed, except changes
required by unforeseeable events; and
- The controlled taxpayer's total actual cost savings
or profits earned for the year under examination and all
past years are no less than 80 percent or no more than
120 percent of the cost savings or profits foreseeable
when the comparability of the uncontrolled agreement was
established. Income Tax Regs. §
1.482-(4)(f)(2)(ii)(B).
The third exception applies where
there is no CUT, i.e., no uncontrolled transaction
involving the same or a comparable intangible. The third
exception requires that:
- The controlled taxpayers enter into a written
agreement providing for consideration each year subject
to the agreement,
- The consideration be arm's length for the first
year,
- "Relevant supporting documentation" be prepared
contemporaneously with the execution of the controlled
agreement,
- No substantial changes in the functions performed by
the controlled transferee occur except changes that were
not foreseeable and
- The aggregate actual cost savings or profits earned
for the year under examination and all past years are
not less than 80 percent or more than 120 percent of the
foreseeable cost savings or profits. Income Tax Regs.
§ 1.482-4(f)(2)(ii)(C).
The fourth exception precludes
periodic adjustments where the cost savings or profits fall
outside of the 80 percent to 120 percent range, if caused by
"extraordinary events" which could not reasonably have been
anticipated and all of the requirements of the second or
third exception have otherwise been met. Income Tax Regs.
§ 1.482-4(f)(2)(ii)(D). The final regulations include an
example, Income Tax Regulations section 1.482-4(f)(iii),
Example 3, where the "extraordinary event" is an earthquake.
The preamble to the final regulations states that the
failure of a market to develop as anticipated is not an
"extraordinary event."
The fifth exception applies to
licenses of more than five years and precludes any periodic
adjustment after five years if no adjustments were required
because the second or third exception applied during the
first five years. Income Tax Regs. §
1.482-4(f)(2)(iii)(E).
Ownership of Intangible Property
As with the 1968 regulations, the
final regulations in Income Tax Regulations section
1.482-4(f)(3)(ii) require that arm's-length consideration be
paid when intangible property is transferred from one member
of a controlled group to another. However, the final
regulations differ from the 1968 regulations in that the
final regulations contain separate rules for "legally
protected" intangible property and intangible property which
is not "legally protected."
Intangible Property that is "Legally Protected"
Income Tax Regulations section
1.482-4(f)(3)(ii)(A) provides as follows concerning "legally
protected" intangible properly:
"The legal owner of a right to exploit an
intangible ordinarily will be considered the owner for
purposes of this section. Legal ownership may be
acquired by operation of law or by contract under
which the legal owner transfers all or part of its
rights to another." [Emphasis added.]
Significantly, the final
regulations provide that intangible property such as
trademarks may have multiple owners, with separate
controlled members owning exploitation rights in different
geographic areas. In this regard, Income Tax Regulations
section 1.482-4(f)(3)(i) provides:
"Because the right to exploit an intangible can be
subdivided in various ways, a single intangible may have
multiple owners for purposes of this paragraph (3)(i).
Thus, for example, the owner of a trademark may license
to another person the exclusive right to use the
trademark in a specified geographic area, for a
specified period of time (while otherwise retaining the
right to use the intangible). In such a case, both the
licensee and the licensor will be considered owners for
purposes of this paragraph (f)(3)(i), with respect to
their respective exploitation rights."
Intangible Property that is Not "Legally Protected"
Income Tax Regulations section
1.482-4(f)(3)(ii)(B) provides the ownership rules for
intangible property that is not "legally protected." Under
this section, the "developer" of non-legally protected
intangible property is treated as the owner. The developer
is "ordinarily" the controlled taxpayer bearing the largest
portion of the direct and indirect costs of development.
This is essentially the ownership rule under the 1968
regulations.
The Final Regulation "Cheese" Examples
The final regulations include
three examples in Income Tax Regulations section
1.482-4(f)(3)(iv) involving a foreign producer of cheese.
The foreign producer markets the cheese in the U.S. through
a U.S. distribution subsidiary using the trade name "Fromage
Frere." These three examples have been the subject of much
discussion in the tax press because of their implications
concerning ownership of intangible property.
In the first "cheese" example,
Income Tax Regulations section 1.482-4(f)(3)(iv), Example 2,
the U.S. subsidiary incurs expenses for developing the U.S.
market for Fromage Frere cheese. The expenses, which include
marketing and advertising expenses, are not reimbursed by
the foreign parent and are described as comparable to the
levels of expense incurred by independent distributors. The
example concludes that because the U.S. subsidiary would
have been expected to have incurred similar expenses even if
unrelated to the foreign parent, no allocation is necessary
from the foreign parent to the U.S. subsidiary. That is, the
U.S. subsidiary is not treated as having performed marketing
services on behalf of the foreign parent, requiring a
services allocation.
In the second "cheese" example,
Income Tax Regulations section 1.482-4(f)(3)(iv), Example 3,
the facts are the same except that the expenses incurred by
the U.S. subsidiary are "significantly larger" than the
expenses incurred by independent distributors under similar
circumstances. Further, the foreign parent does not
reimburse the U.S. subsidiary for these "significantly
larger" marketing expenses. The example states that an
independent distributor would not have incurred such levels
of marketing expense to develop an unrelated party's
trademark. Therefore, the example concludes, the marketing
expenditures in excess of the amount that would have been
incurred by an independent distributor under similar
circumstances reflect services performed by the subsidiary
for the benefit of the foreign parent. The example states
that such services add to the value of the foreign parents'
trademark. The example concludes with the district director
making an allocation from the foreign parent to the U.S.
subsidiary of an amount equaling the fair market value of
the services deemed performed by the U.S. subsidiary.
In the third "cheese" example,
Income Tax Regulations section 1.482-4(f)(3)(iv), Example 4,
the facts are the same except that the U.S. subsidiary
concludes a "long term agreement" and thereby receives the
"exclusive right" to distribute cheese in the United States
under the foreign parent's trademark. The example states
that the U.S. subsidiary purchases the cheese from the
foreign parent at an arm's-length price, a fact apparently
added to indicate that the U.S. subsidiary did not receive
reimbursement for its "significant" advertising expenses
through a reduced purchase price. From these premises, the
example somewhat cryptically concludes that the U.S.
subsidiary is the "owner" of the trademark pursuant to
paragraph (f)(3)(ii)(A) because its "conduct is consistent
with that status." The example concludes that because the
U.S. subsidiary is considered the "owner" of the trademark,
no services allocation need be made. The implication is that
the U.S. subsidiary's advertising efforts were made to
develop its U.S. ownership rights to the trademark.
The cross reference in Example 4
(the third "cheese" example) to Income Tax Regulations
section 1.482-3(f)(3)(ii)(A) is to the above-quoted language
stating that a single intangible may have multiple owners;
both Income Tax Regulations section 1.482-3 (f)(3)(ii)(A)
and Example 4 involve the transfer of an "exclusive right"
to a trademark to a related party for either a "specified
period" or a "long term" period. Thus, Example 4 could be
cited by the Service in arguing that an intangible such as a
trademark may have multiple owners–including a U.S.
distribution subsidiary. Taxpayers may similarly argue that
a foreign subsidiary that promotes a trademark outside the
U.S. should be treated as the owner of the foreign rights.
However, the lack of definitions of terms such as
"significantly larger" marketing expenses creates
considerable uncertainty as to the application of these
ownership rules. Also, the "cheese" examples assume that the
price paid to the parent for the cheese is arm's length.
This is often not the case, which may complicate the
analysis of the question of whether the extraordinary
promotional activity is reimbursed through the transfer
price of the trademarked product.
Another example in the final
regulations is relevant as to the ownership issue. Income
Tax Regulations section 1.482-1(d)(3)(ii)(c) is an example
where a U.S. subsidiary for six years incurs marketing
expenses promoting its foreign parent's trade name. The
marketing expenses are described as in excess of the level
of such expenses that would be incurred by a comparable
distributor. In effect, the example concludes that the U.S.
subsidiary would not have incurred such expenses over such a
period at arm's length unless an agreement existed allowing
the U.S. subsidiary to benefit from such expenditures, which
under the example result in the foreign parent's trade name
commanding a "price premium" in the U.S. The example
concludes that the district director may impute an agreement
whereby the foreign parent allows the U.S. subsidiary to
earn "an appropriate portion" of the "price premium"
attributable to the trademark, implying a price allowance to
compensate the U.S. subsidiary for the extraordinary
marketing expenses. This is similar to the result of the
third "cheese" example where the U.S. subsidiary is treated
as not performing services, but instead as owning a U.S.
marketing intangible, and presumably earning the income
attributable thereto.
The 1968 Regulation Ownership Rules
The 1968 regulations provide that
when one member of a controlled group transfers intangible
property to another member of the group, the district
director may make appropriate allocations to reflect
arm's-length consideration for the transferred intangible
property. Income Tax Regs. § 1.482-2(d)(1)(i) (1968).
But the district director may not make such an allocation
until the "developer" of the intangible property transfers
it to another member of the controlled group.
"[W]here one member of a group of related entities
undertakes the development of intangible property as a
developer . . . , no allocation with respect to such
development activity shall be made . . . until such time
as any property developed, or any interest therein, is
or is deemed to be transferred, sold, assigned or
otherwise made available in any manner in a transfer
subject to the rules of this paragraph." Income Tax
Regs. § 1.482-2(d)(1)(ii)(a) (1968).
Income Tax Regulations section
1.482-2(d)(1)(ii)(c) (1968) contains the rules for
determining which member of a controlled group is the
"developer" of intangible property.
"The determination as to which member of a group of
related entities is a developer and which members of the
group are rendering assistance to the developer in
connection with its development activities shall be
based upon all of the facts and circumstances of the
individual case. Of all the facts and circumstances to
be taken into account in making this determination,
greatest weight shall be given to the relative amounts
of all the direct and indirect costs of development and
the corresponding risks of development borne by the
various members of the group . . . . Other factors
that may be relevant in determining which member of the
group is the developer include the location of the
development activity, the capabilities of the various
members to carry on the project independently, and the
degree of control over the project exercised by the
various members." [Emphasis added.]
Thus, the 1968 regulations, in
determining which controlled entity is the "developer,"
provide that the "greatest weight" should be given to the
relative development costs and corresponding risks borne by
the members of the controlled group. Lesser weight may be
given to the other factors listed in the regulations, such
as the location of the development activity or control over
the project.
Notably, the 1968 regulations do
not list legal ownership of the intangible, or
contractual relationships within the controlled group, among
the factors to be considered in determining ownership of
intangible property. When the Service issued the final
regulations, it acknowledged in the preamble that the prior
regulations had "disregarded legal ownership."
"The 1993 [proposed] regulations also provide rules for
identifying the owner of an intangible for purposes of
section 482 (the developer-assister rule). These rules
generally track rules provided in prior regulations,
under which the owner normally is considered to be the
controlled taxpayer that bears the greatest share of the
risk of developing the intangible. The party that bears
the greatest risk of development generally is determined
by identifying costs of development. Under this rule the
owner for purposes of income allocation under section
482 would not necessarily be the legal owner.
. . . . .
"The 1993 regulations provided that, for purposes of
section 482, intangible property generally would be
treated as owned by the controlled taxpayer that bore
the greatest share of the costs of development [i.e.,
the 1968 regulation rule]. This rule was criticized by
many commentators, principally because it disregarded
legal ownership." T.D. 8552, 1994-2 C.B. 93, 96, 108
(emphasis added).
Allocations with Respect to Assistance Provided to the
Owner of Intangible Property
Under (Income Tax Regulations section
1.482-4(f)(3)(iii) allocations may be made to reflect
arm's-length consideration for assistance provided to the
owner of an intangible in connection with the development or
enhancement of the intangible. Such assistance may include
loans, services or the use of tangible or intangible
property. Assistance does not, however, include expenditures
of a routine nature that an unrelated party dealing at arm's
length would be expected to incur under similar
circumstances. See the discussion below of Income Tax
Regulations section 1.482-2(b)(8) concerning such
"ancillary" services.
Lump Sum Payments
Income Tax Regulations section
1.482-4(f)(5) provides that if an intangible is transferred
for a lump sum, the lump sum must be "commensurate" with the
income attributable to the intangible. The regulation states
that a lump sum will be commensurate with the income if the
"equivalent royalty amount" is equal to an arm's-length
royalty. The "equivalent royalty amount" is the amount
determined by treating the lump sum as an advance payment of
a stream of royalties over the useful life of the
intangible, taking into account the projected sales of the
licensee as of the date of the transfer.
To determine the "equivalent
royalty amount," the taxpayer must:
- Determine the projected sales of the licensee of the
intangible over the projected life of the intangible (or
for the period covered by the license agreement, if
shorter);
- Determine the present value of the projected sales
by applying an appropriate discount rate, taking into
account the risk involved;
- Divide the lump sum payment by the present value of
the projected sales to determine the "equivalent royalty
rate;" and
- Apply the "equivalent royalty rate" to the projected
sales to determine the "equivalent royalty amount" for
each year over the life of the intangible. Income Tax
Regs. § 1.482-4(f)(5)(i).
The "equivalent royalty amount"
for each year is subject to "periodic adjustments" to the
same extent as actual royalty payments. Id. Thus,
although the Service's initial focus may be on the year the
lump sum amount is paid, the regulations permit the Service
to re-examine the issue each year to determine if the
"equivalent royalty amount" is "commensurate" with the
income attributable to the intangible.
It can be anticipated that the
Service will not hesitate in challenging lump sum payments,
particularly where valuable intangibles are involved.
Ancillary Services
Income Tax Regulations section
1.482-2(b)(8) states that ancillary services provided in
connection with the transfer of intangible property do not
require separate arm's-length compensation for the services
rendered, but instead are treated as being included in the
price of the property transferred. Thus, technical
assistance provided to a foreign affiliate to install a
manufacturing process does not require separate compensation
for the services. However, such services are listed in
Income Tax Regulations section
1.482-4(C)(2)(iii)(B)(2)(viii) as one of a number of
"particularly relevant" factors to be considered in
determining comparability under the CUT method.
Computer Software Regulations
On September 30, 1998, the Service
issued final regulations, Income Tax Regulations section
1.861-18, concerning the characterization of income derived
from transfers of computer software. The regulations
generally treat computer software programs as falling within
one of the following four categories:
- A transfer of a copyright right in the computer
program,
- A transfer of a copy of the computer program (a
copyrighted article),
- The provision of services for the development or
modification of the computer program or
- The provision of know-how related to computer
programming techniques. Income Tax Regs. §
1.861-18(b)(1).
The regulations distinguish
between the transfer of a "copyright right" and the transfer
a "copyrighted article." Income Tax Regs. §
1.861-18(a)(2). The regulations provide rules for
determining whether the transfer of a "copyright right"
should be treated as a sale or exchange or as a license
generating royalty income. Id. As to the transfer of
a "copyrighted article," the regulations provide rules for
determining whether the transaction should be classified as
a sale or exchange or as a lease generating rental income.
Id.
The transfer of a computer program
is treated as a transfer of a "copyright right." If the
transferee acquires one or more of the following rights:
- The right to make copies of the computer program for
purposes of distribution to the public by sale or other
transfer of ownership or by rental, lease or lending,
- The right to prepare derivative computer programs
based on the copyrighted computer programs,
- The right to make a public performance of the
computer program or
- The right to publicly display the computer program.
Income Tax Regs. § 1.861-18(c)(2).
IT
The regulations state that term
"copyrighted article" includes a copy of a computer program
from which the work can be perceived, reproduced or
otherwise communicated, either directly or with the aid of a
machine or device. The copy of the program may be fixed in
the magnetic medium of a floppy disk or in the main memory
or hard drive of a computer. Income Tax Regs. §
1.861-18(c)(3).
The determination of whether a
transaction involves the provision of services as opposed to
the transfer of a copyright or a copyrighted article is
based on the facts and circumstances, including the intent
of the parties (as evidenced by their agreement and conduct)
as to which party is to own the copyright rights in the
computer program and how the risks of loss are allocated
between the parties. Income Tax Regs. § 1.861-18(d).
The regulations provide that the
provision of information with respect to a computer program
will not be treated as the provision of "know-how"
unless the information is (i) information relating to
computer programming techniques, (ii) furnished under
conditions preventing unauthorized disclosure, specifically
contracted for by the parties and (iii) subject to trade
secret protection. Income Tax Regs. § 1.861-18(e).
For purposes of the section 482 regulations "know-how" may
constitute an intangible irrespective of whether it is
subject to trade secret protection.
The regulations provide that the
determination of whether the transfer of a "copyright right"
is a sale or an exchange is made on the basis of whether,
taking into account all facts and circumstances, there has
been a transfer of all "substantial rights" in the
copyright. A transaction that does not constitute a sale or
exchange because not all substantial rights have been
transferred, will be classified as a license generating
royalty income. Income Tax Regs. § 1.861-18(f)(1).
Finally, the regulations provide
that the determination of whether a transfer of a
"copyrighted article" is a sale or exchange is made on the
basis of whether, taking account all facts and
circumstances, the "benefits and burdens of ownership" have
been transferred. A transaction that does not constitute a
sale or exchange because insufficient burdens and benefits
have been transferred–such that a person other than the
transferee is properly treated as the owner–will be
classified as a lease generating rental income. Income
Tax Regs. § 1.861-18(f)(2).
Effective Dates
Income Tax Regulations section
1.482-1(j) provides that the final regulations are generally
effective for taxable years beginning after October 6, 1994.
Taxpayers may elect to apply the final regulations to any
open year, but if such an election is made, the final
regulations will apply to the initial year and all later
years.
Income Tax Regulations section
1.482-1(j)(3) states that the final sentence of Internal
Revenue Code section 482 containing the "commensurate with
income" language is generally effective for taxable years
beginning after December 31, 1986. For periods after
December 31, 1986, but before the October 6, 1994 effective
date of the final regulations, the final sentence of section
482 must be applied "using any reasonable method not
inconsistent with the statute." Income Tax Regulations
section 1.482-1(j)(3) states that the IRS considers a method
that applies the final regulations "or their general
principles" to be a "reasonable method."
Income Tax Regulations section
1.482-1(j)(4) states that the final regulations do not apply
for transfers or licenses to foreign persons before November
17, 1985 or before August 17, 1986, for transfers or license
to other persons. However, the final regulations do apply
for transfers or licenses before such dates as to property
transferred pursuant to an earlier and continuing agreement
if the transferred property was not in existence or owned by
the taxpayer on or before such dates. International Tax
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