Taxation of Licensing Agreements
The Innolux case conveys different lessons. Companies outside the U.S. are generally aware that maintaining U.S. subsidiaries increases the risks and costs of litigation, as plaintiffs often direct U.S. lawsuits, subpoenas, and disclosure requests to the subsidiary in addition to or in place of the parent company, even if the subsidiary is clearly the wrong party because the subsidiary will be forced to defend itself. Increased leverage of the applicant. In addition, maintaining a U.S. subsidiary, as this case notes, can result in a costly shift in the tax burden in intellectual property licensing disputes, so foreign companies should consider closing U.S. subsidiaries that are no longer needed. The cost of closing a U.S.
subsidiary can be low and the savings can be substantial. Finally, it should be noted that issues relating to the international patent licensing fee are neither trivial nor unique to Taiwan. In September 2016, Microsoft filed a lawsuit with South Korean tax authorities, demanding a refund of 600 billion won ($533 million) in taxes it allegedly overpaid, based on patent royalties it paid to Samsung and other Korean companies. Microsoft claims that patent licenses covering jurisdictions other than Korea have not been properly taxed. Other companies have reportedly filed similar claims with Korean tax authorities, including NTP Inc., Evident Technologies, Saxon Innovations and Semiconductor Components. The CIP contains two scenarios with corresponding analyses of the correct tax treatment of advance payments and milestone payments. While neither scenario contains facts that exactly match Mylan`s, the “Initial Considerations” section offers interesting information about the IRS`s handling of these types of agreements. The PIC states that when reviewing these agreements, auditors should first consider whether it is the sale or license of intangibles, as this could result in “radically different tax consequences.” The IPC goes on to say that, given the nature of the life sciences industry, including the desire of companies to share their know-how and enter into joint research agreements and other collaborative partnerships in the drug development process, pharmaceutical companies often address the question of whether a transaction is a license or a sale.
The main tax difference between a license and a sale transaction is that royalty payments are taxed as ordinary income and the proceeds of sales as capital gains. In both cases, the U.S. court issued a decision that, at first glance, appeared to violate the requirements of Taiwanese law. As in most countries, Taiwanese tax law requires all local companies that pay intellectual property royalties to a non-resident licensor to withhold a portion of the payments (20% in the case of Taiwan) and pay them to the tax authorities to meet the licensor`s tax liability. Essentially, the foreign licensor is liable for the taxes, but the local licensee acts as a collection agency for the tax authorities. Although Taiwanese law explicitly states that 20% of all royalty payments are “withheld” by Taiwanese licensees from foreign licensors and paid to the authorities, the court found no reason why a Taiwanese company cannot comply with the law by paying taxes in addition to royalty payments instead of deducting taxes from payments. The court found that Wistron had not provided any evidence to the contrary, and such a finding was supported by the people`s Liberation Army`s language, which required Wistron to make payments in full and without holdbacks. In both of the above cases, a United States court ruled that the Taiwanese company was not entitled to withhold taxes on the royalties as required by Taiwanese tax law; Instead, the Taiwanese company had to pay the licensor`s taxes out of its own pocket. While the facts differ in both cases, they both offer important lessons to avoid, which can easily represent a multi-million dollar mistake.
In October 2007, the IRS issued a Coordinated Issuance Document (CIP) for the biotechnology and pharmaceutical industries entitled Nonrebackable Upfront Fees, Technology Access Fees, Milestone Payments, Royalties and Deferred Income Under a Collaboration Agreement (LMSB-04-1007-073). As of January 21, 2014, the PICs are no longer binding on IRS examiners, but are still available to auditors for advice. The ICP deals with the tax treatment of advance payments, milestones and royalties under cooperation agreements that exist between independent national parties in the pharmaceutical and biotechnology industries, usually for drug development. Cooperation agreements are defined as agreements on joint research, experiments or developments, as well as agreements on the sharing of know-how or patents for research, experimentation or development purposes. So what can we learn from the Wistron case? First of all, in order to avoid surprises, the parties should discuss tax obligations during license negotiations, in the license agreement and in a dispute resolution procedure, otherwise a third party can decide on these issues and it can be assumed that objections have been waived. Second, although in most countries the law may impose a tax burden on licensors, it may be possible to override this legal presumption through contractual language formulations. The language of the APL Mondis/Wistron has achieved this. Like most countries, Taiwan has double taxation treaties in place with a few dozen countries that allow a foreign licensor to apply for a reduction in withholding tax if they can prove that they paid taxes on the same royalties in their home country.
However, the demand for such a reduction is secondary. The first step is for the licensee to withhold 20% of his payments to the licensor and pass on this withholding tax to the authorities. Mondis v. Chimei-Innolux (“Innolux”) involved the same NPE and Innolux, another Taiwanese manufacturer of consumer electronics. In this case, there was no license agreement. Instead, Mondis sued Innolux for patent infringement and won a final verdict on more than $15 million in past damages, as well as ongoing royalties. The court then scheduled a hearing to clarify several questions about the final verdict. In particular, while the court had asked Innolux to comply with the decision “without discounts or deductions”, Innolux argued that it was required by law to withhold 20% of payments, and under a double taxation agreement between the United Kingdom (Mondis` residence) and Taiwan, Mondis should be entitled to a 50% refund on all taxes withheld. In November 2016, a U.S.
District Court ordered a Taiwanese company to pay taxes on royalties it paid to a foreign licensor, although these taxes are usually the licensor`s obligation. Mondis Technology Ltd.c. Wistron Corporation, Case No. 15-cv-02340-RA (S.D.N.Y. 3 November 2016). A few years earlier, the same licensor had forced another Taiwanese licensee to pay his Taiwanese taxes. Mondis Technology Ltd.c. Chimei-Innolux Corp., Case No.
2:11-cv-378-JRG (E.D. Tex. 30 April 2012). The IRS states that cooperation agreements can take the form of a license agreement, an alliance agreement, a co-commercialization agreement, or a functional equivalent of it. These agreements typically include upfront payments, which are non-refundable payments due upon signing the agreement or later if the parties agree. Advance payments are not constant. Cooperation agreements also typically require milestone or instalment payments, which are non-refundable payments due as a result of successful research (i.e., they are conditional). In Mondis v. Wistron, the parties have entered into a patent licensing agreement (“PLA”) allowing Wistron, a Taiwanese manufacturer of consumer electronics, to use certain patents of Mondis, a non-practicing English company, provided that Wistron pays certain royalties and “bears all duties, duties and taxes (including, but not limited to, withholding tax, sales tax and value added tax); and pay.” When a dispute arose over Wistron`s payments under the agreement, the parties appeared before arbitration and the court issued an arbitral award requiring Wistron to pay Mondis more than $3 million in royalties, interest and unpaid fees.
The award said nothing about the tax obligations of either side. The main takeaways are to pay attention to tax issues throughout the licensing process, when calculating license numbers and rates, when drafting agreements, payments, and resolving disputes, and to quickly resolve these issues with counterparties and decision-makers to avoid costly surprises….