A review of third-party license agreements: are periodic adjustments arm's length?

• Author: McShan, W. Scott
• Position: Section 482 White Paper

A Review of Third-Party License Agreements: Are Periodic Adjustments Arm's Length?

INTRODUCTION

On October 18, 1988, the Department of the Treasury and the Internal Revenue Service issued "A Study of Inter-company Pricing"(1) to explain the Government's position regarding the changes made by the Tax Reform Act of 1986 to section 482 of the Internal Revenue Code, pertaining to transfers and sales of intangible assets between related parties. The study responded to the congressional request, discussed in the Conference Committee report, for a review of the administration of section 482. The 1986 Act amended section 482 by adding the following sentence:

(1) U.S. Treasury Department (Office of International Tax Counsel, Office of Tax Analysis) and U.S. Internal Revenue Service (Office of Assistant Commisioner (International) and Office of Associate Chief Counsel (International), A Study of Intercompany Pricing (Discussion Draft, October 18, 1988)(hereinafter cited as "the White Paper').

In the case of any transfer (or license) of intangible

property (within the meaning of section 936(h)(3)(B)),

the income with respect to such transfer or license

shall be commensurate with the income attributable

to the intangible.

It also added a similar sentence to sections 367(d) and 936(h). These new provisions generally apply to taxable years beginning after December 31, 1986, but only with respect to transfers after November 16, 1985 (except for section 936(h) where all transfers of intangibles are covered regardless of the date of transfer).

The House Ways and Means Committee interpreted the commensurate-with-income language to include the necessity for "adjustments over time."(2) This interpretation is based on the belief that actual profit experience should be used in determining the appropriate compensation for the intangible and that periodic adjustments should be made to the compensation to reflect substantial changes in intangible income as well as changes in the economic activities performed and economic costs and risks borne by the related parties in exploiting the intangibles.(3)

(2) H.R. Rep. No. 426, 99the Cong., 1st Sess. 425 (1985).

(3) See White Paper at 48.

In addressing the congressional mandate, the IRS evinced the belief that contractual arrangements between unrelated parties contain some mechanism to change the terms of the contracts to take into account unanticipated events.(4) To support this position the IRS conducted a study of licensing agreements between unrelated parties. The IRS presented the results of its study in Appendix D of the White Paper.

(4) White Paper at 63. This position is contrary to legal precedent established in R.T. French Co. v. Commisioner, 60 T.C. 836 (1973). See Bausch & Lomb v. Commissioner, 92 T.C. No. 33 (Mar. 23, 1989), for additional Tax Court support of R.T. French.

The IRS conducted "[a] very preliminary review of unrelated party licensing agreements obtained from the files of the Securities and Exchange Commission [SEC] . . . [which] seems to support [adjustments over time]."(5) The IRS analyzed 60 of the 500 - plus agreements that had been filed with and were available at the SEC. The IRS explained in the White Paper that "[t]he choice of agreements in [its] sample was largely dictated by the ease of discovery and the availability of documents within the SEC's files." Two-thirds of the agreements the IRS examined are from Standard Industrial Classifications (SIC) for manufacturing firms producing "pharmaceutical preparations, toilet preparations, electronic computing equipment, semi-conductors, surgical and medical equipment, and ophthalmic goods." The other 20 agreements are for the services industry, mostly within the SICs for computer programming, computer software, and research and development laboratories.(6)

(5) White Paper at 63 (emphasis added).

(6) White Paper at Appendix D, 1.

Based on experience, many taxpayers and tax advisers doubted the validity of the IRS's conclusion that adjustments over time are arm's length. (Indeed, questions about the matter were fueled by the IRS's equivocal "seems to support" language.) In order to develop an empirical base from which to verify or challenge the White Paper's conclusions, a larger study (using a more representative sample) of licensing agreements was conducted. This article summarizes our analysis of the surveyed licensing agreements. In analyzing the agreements, we focused on the three issues relating to the adjustments-over-time concept:

* length of agreements

* termination and renegotiation of agreements

* compensation.

To support the IRS contention that licensors can force renegotiation of royalties when profitability of a licensed product unexpectedly rises, either (i) license agreements must contain termination or renegotiation clauses that can be activated by the licensor without showing cause or (ii) license agreements must be short-term agreements that can be renewed at their termination. The existence of neither of these conditions is supported by the data we analyzed.

Specifically, we found that agreements...