Background

The licensing of foreign-owned intellectual property by domestic companies is commonplace in today’s global economy. These licensing agreements often are complex arrangements requiring an understanding of numerous and intricate legal issues in order to maximize efficiency and profitability. And in some cases, having only a little knowledge can be a dangerous thing. For example, although most domestic licensees are generally aware that there are federal and state tax implications to an agreement to license intellectual property from a foreign company, many lack sufficient understanding of the intricacies of this area of tax law to ensure that the license is optimally structured for their par­ticular circumstances. This article provides prospective licensees with a practical working understand­ing of these basic tax considerations.

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Tax Implications of Sale versus License of

Intangible Property

Generally, the United States taxes its citizens, resident aliens, and domestic corpora­tions on their worldwide income, without regard to the country from which such income was derived. Conversely,the United States asserts a much more limited taxing jurisdiction over foreign corporations, tax­ing only income from United States sources and income effectively connected with a trade or business conducted by the foreign company within the United States.

For example, if a foreign com­pany sells property (including intangible property) to a United States buyer (for consideration not in the form of royalties), the foreign company will not be subject to tax unless it has some type of business presence in the United States. Therefore, a for­eign transferor of intellectual property may avoid paying any United States tax if it relin­quishes ownership of the prop­erty so that the transfer is con­sidered to be a sale. However, royalties from the license rather than the sale of such property will be subject to United States taxation, because the licensor will be viewed as deriving income from sources within the United States. Moreover, the rate of taxation is relatively steep, at 30% of the royalty payments.

Obligations of Licensee as Withholding Agent

If you are the licensee in such a scenario, it is important to

note that you will be considered a “withholding agent,” and will be held personally liable for fail­ing to withhold the required amounts from your royalty pay­ments to the licensor. It is imperative that the appropriate amounts are withheld, as this liability is independent of the tax liability of the foreign per-son to whom the payment is

made. Furthermore, if you fail to withhold and the foreign payee fails to satisfy its United States tax liability, then both you and the foreign licensor are liable for tax, as well as interest and any applicable penalties. These are all situations that could easily be avoided with sim­ple knowledge of the general withholding concepts.

Fortunately, the act of with-holding is relatively simple. Thelicensee must report the royalty payments on Form 1042-S and file a tax return on Form 1042. These forms are widely avail-able and are easy for a licensee or accountant to complete.

The Impact of Tax Treaties

Additionally, there are many treaties in existence that reduce or sometimes eliminate the

onerous 30 % tax rate on royaltypayments. It is imperative that aprospective licensee be aware of these individual rates, or at the

very least, the fact that the tax rate for any given transaction depends in part on the country from which the intellectual property is being licensed. If a licensee withholds more than the required amount, an acrimo­nious business relationship almost surely will result, with the possibility that the licensor will terminate the license because of underpayment. If a licensee withholds too little, it could be subjecting itself to sub­stantial liability. Furthermore, aknowledge of the applicable tax rates will give a prospective licensee greater insight when negotiating a dollar amount for royalties to be paid, as many licensees automatically assume that the licensor’s “take home” income will be reduced by the 30% tax.

Hypothetical: United States, Canada and China

For instance, Company C, a Canadian company, and Company U, a United States company, are negotiating a licensing agreement for industri­al “know how” that will greatly increase manufacturing efficien­cy. Company C demands total royalty payments of $100,000. Company H, a Chinese compa­ny, possesses industrial “know how” that will achieve the same result as Company C’s process. Company H also demands total royalty payments of $100,000.

If Company U understands that the United States – Canada

		Copyright Royalties
Country	Industrial Royalties	Motion Picture & Television	Other
Austria	0	10	0
Barbados	5	5	0
Belgium	0	0	0
Canada	0	10	0
China	10	10	10
Czech Republic	10	0	0
Denmark	0	0	0
Egypt	0	0	15
Estonia	5	10	10
France	5	0	0
Germany	0	0	0
Greece	0	30	0
India	10	15	15
Indonesia	10	10	10
Ireland	0	0	0
Israel	15	10	10
Italy	10	8	5
Japan	0	0	0
Mexico	10	10	10
Russia	0	0	0
Spain	0	0	0
Switzerland	0	0	0
Turkey	5	10	10
United Kingdom	0	0	0

 

tax issues and require careful consideration before attempting to use them. Regardless of whether a prospective licensee is contem­plating a complex, tax-minimizing international licensing structure, a familiarity with the United States taxation principles regarding international royalty payments will give the licensee an advantage in negotiating all of its licensing agreements.

Micah W. Bloomfield is a partner and Ian S. Shainbrown is an associ­ate in the Tax Practice Group of Stroock & Stroock & Lavan LLP. Mary Catherine Di Nunzio is an associate in Stroock ’s Intellectual Property Practice Group.