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Company Comments on Guidance on Cross-Licensing Arrangements

APR. 21, 2006

Company Comments on Guidance on Cross-Licensing Arrangements

DATED APR. 21, 2006
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From: William_Morin@amat.com

 

Sent: Friday, April 21, 2006 9:50 AM

 

To: Notice Comments

 

Cc: Bill_Barrett@amat.com; Hinding John E

 

Subject: Notice 2006-34

 

 

Applied Materials, Inc., submits the attached comments in response to Notice 2006-34, requesting information regarding the taxation of cross-licensing agreements.

Substantive questions about Applied Materials' comments should be directed to Mr. William C. Barrett, vice president for tax and trade, at 408.235.4389. Questions regarding document format or readability should be directed to me at 202.638.4434, ext. 5.

 

William G. Morin

 

Director, Government Affairs

 

Applied Materials, Inc.

 

1400 I Street, NW, Suite 540

 

Washington, DC 2005

 

April 21, 2006

 

 

Office of Associate Chief Council (International)

 

Attention: John E. Hinding (Notice 2006-34)

 

CC: INTL:6

 

Internal Revenue Service

 

1111 Constitution Avenue, NW

 

Washington, DC 20224

 

 

Re: Notice 2006-34

Dear Sir:

Applied Materials, Inc., submits the following comments in response to Notice 2006-34 requesting comments on the "Taxation of Cross Licensing Arrangements."

Joint Venture Technology Cross Licensing. In a joint venture (JV) arrangement involving cross-licensed intellectual property (IP), each party's IP is valued. To the extent relative IP contributions are unequal, partner contributions may be equalized with cash or other in-kind contributions. Unequal contributions may also be equalized through royalty payments, negotiated at arm's length, with appropriate withholding tax and income taxation.

U.S. Tax Consequences with U.S. Ownership or Control of Foreign JV Greater Than Fifty Percent. In situations where a U.S. partner has greater than fifty percent control of a foreign JV, U.S. tax law is clear. Any contribution of U.S. intangible property is subject to deemed U.S. income taxation under the "commensurate with income" standard.1 Deemed royalty payments, under the "commensurate with income" standard, are sourced based on the "make or use" or "sales" location, and reduce the earnings and profits (E&P) of the foreign joint venture.2 As such, in most JV situations deemed royalties/deemed contingent sales of U.S. IP would produce only a temporary increase in U.S. income tax. The tax is temporary because the deemed amounts reduce profits of the JV and as a result, profits available for distribution are reduced.3

Notice 2006-34 seems most concerned with a "deemed" license of foreign IP where the deemed transaction would be an outbound (out of the U.S.) royalty or contingent payment sale. A deemed outbound royalty payment might arguably attract a withholding tax but also creates a deemed U.S. tax deduction and 35-percent tax benefit for the U.S. party.4 U.S. tax treaties govern the withholding tax rate and for most of our trading partners, withholding tax rates on royalties are zero percent.5 Further, it is important to note that a deemed withholding tax may override existing income tax treaties for at least two reasons. First, withholding tax applies to royalties "paid," not "deemed paid" under income tax treaties.6 Second, there may be no "double taxation" relief for the foreign party under local country tax law for withholding tax on deemed royalties.

U.S. Tax Consequences with U.S. Ownership or Control of Foreign JV Less Than Fifty Percent. The discussion above also applies in the context of a less-than-fifty-percent JV ownership interest, with some important distinctions. If, in the aggregate, U.S. parties to a foreign JV do not control greater than fifty percent of the JV, then the "commensurate with income" standard does not technically apply. However, this should not produce a fundamentally different tax result. As discussed above, deemed royalty income should produce corresponding deemed royalty expense when computing the JV's earnings and profits (or deemed U.S. royalty deduction and income in the JV's earnings and profits), resulting in no incremental increase in U.S. income tax over time.

Withholding Tax on Deemed Outbound Royalties Becomes Tax Burden of U.S. Companies. Royalty payments are paid to foreign parties net of any withholding tax. The withholding tax is remitted to the U.S. Treasury. In a deemed royalty situation, the tax withheld is the nominal liability of the foreign party, but if there is no other consideration being paid as part of the economic or financial arrangement, it is the U.S. party as the withholding agent that remits cash to Treasury. If there is another flow of income to the foreign party out of the same transaction, U.S. companies could deduct the withholding tax from that payment but this will generate significant controversy between U.S. and foreign counter-parties. This controversy would likely generate requests for relief from (an already over-burdened) Competent Authority.7

Deemed Withholding Tax Applies Only to U.S. Sourced Royalties. The source of "deemed royalties" is an important consideration because only "U.S.-sourced" royalties would be subject to U.S. income tax withholding. Royalties are "U.S. sourced" if the intangible is used in the United States.8 For example, "use" of intangible property in the United States can occur through U.S. manufacturing and sales of licensed intellectual property to U.S. customers.9

Sourcing any deemed royalty becomes the capstone to a difficult three-step process to arrive at any deemed withholding tax. First, the intellectual property must be properly valued. Second, an appropriate "arm's length" royalty rate must be identified. Third, the portion of the royalty attributable to U.S. sourced income must be computed.

Summary and Recommendation. Key considerations that militate against Treasury invoking a unilateral administrative position of "deemed" royalties and withholding tax in arm's length cross-license arrangements include the following:

 

1. Valuing the respective intellectual contributions is difficult.

2. Identifying an appropriate royalty rate may be difficult.

3. Sourcing the royalty, upon which a withholding tax would be computed, might be very difficult because where the IP is "used" is not always clear.

4. There is no withholding tax under most income tax treaties with major trading partners.

5. In situations in which a U.S. partner has a controlling interest in a foreign joint venture, any outbound royalty payment will also generate a U.S. tax deduction, creating a net tax benefit to the U.S. taxpayer. Should Treasury adopt a "deemed" royalty administration position, U.S. taxpayers may be tempted to apply a "deemed" outbound royalty position in the affirmative and reduce their overall U.S. tax liability.

6. Inbound royalties triggering "deemed" U.S. taxed royalty income creates a corresponding "deemed" royalty expense to the foreign related party. Foreign earnings and profits are reduced, which in turn reduces U.S. taxable income when those earnings are distributed, offsetting any tax on the inbound "deemed" royalty

7. Withholding tax on outbound "deemed" royalties becomes a de facto economic expense of U.S. taxpayers because the withholding tax does not offset actual payments to a foreign partner.

 

Applied Materials appreciates this opportunity to comment on the taxation of cross-licensing arrangements. Questions about Applied's comments should be directed to me at 408.235.4389 or <bill_barrett@amat.com>.
Sincerely,

 

 

William C. Barrett

 

Vice President, Tax and Trade

 

Applied Materials, Inc.

 

FOOTNOTES

 

 

1 IRC§§ 367(d) and 482.

2 See Treas. Reg. § 1.482-1(g)(2) and Treas. Reg. § 1.367(d)-1T(c).

3 In the context of a foreign JV taxed as a corporation, a deemed inbound royalty produces a temporary U.S. income tax because future JV dividends will be reduced by the amount of deemed royalty payment that reduced the E&P of the foreign JV. In the context of a foreign JV taxed as a pass through or partnership, deemed royalty income and expense offset each other in the same tax year for no (net) U.S. income tax impact.

4 § 267(a)(3) requires matching of expense and income between U.S. parent and related foreign entity. § 267(a)(2) defers expense/income recognition between related parties until amount is "paid." Treas. Reg. § 1.267(a)-3(b)(1) treats amounts "subject to" § 1442 withholding as "paid." Therefore, "deemed" royalty payments "subject to" withholding create a U.S. deduction and corresponding increase in the E&P of the foreign JV.

5 For example, the royalty withholding tax rate for Germany, France, U.K., Japan, Korea, and China is zero percent.

6 For example, see Article 14 of the U.S./Israel Income Tax Treaty. See also IRS § 881 language "[h]ereby imposed for each year a tax of 30 percent of the amount received..." [emphasis added]. A "deemed" withholding tax pursuant to administrative fiat by Treasury, rather than a legislative change, might also violate the Supremacy Clause of the U.S. Constitution: "This Constitution, and the Laws of the United States which shall be made in Pursuance thereof; and all Treaties made, or which shall be made, under the Authority of the United States, shall be the supreme Law of the Land . . . ." Treasury cannot unilaterally override these laws.

7 Competent Authority (which involves negotiations by tax authorities of both countries) is a procedure for resolving situations in which a taxpayer is taxed in a manner that is not in accordance with an income tax treaty. It is also interesting to note that under Article 25(1) of the U.S. model income tax treaty, a taxpayer may present its case to either country's Competent Authority. In other words, the U.S. model treaty contemplates that a U.S. taxpayer may initiate a Competent Authority proceeding against the United States, in an outbound deemed royalty withholding tax situation, wherein the foreign country would be arguing on behalf of the U.S. taxpayer.

8 IRC §§ 862(a)(4) and 861(a)(4).

9 For example, see Rev. Rul. 80-362, 1980-2 C.B. 208.

 

END OF FOOTNOTES
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