Taxation Of Intellectual Property – The Basics

INTRODUCTION

Change driven by development of intellectual property ("I.P.") is now a constant. Whether the I.P. user is a tax adviser accessing a digital library, an auto mechanic interfacing with an engine, or a shopper looking for a specific brand of product, I.P. in all its varied forms serves as an important tool in daily life.

For purposes of U.S. tax law, I.P. can take many forms. As embodied in the Internal Revenue Code ("Code"),1 I.R.S. regulations, and case law, it includes patents, trademarks, copyrights, trade secrets, know-how, and computer software.2

This article presents an overview of the basic U.S. Federal tax considerations of transactions that occur over the life cycle of I.P, from its creation, to its acquisition, its exploitation, and its ultimate sale in a liquidity event.

TAX CONSIDERATIONS OF SELF-CREATED I.P.

Basis

Deduction v. Capitalization

A taxpayer that creates and utilizes I.P. as part of a profitable ongoing trade or business likely will prefer deducting the costs attributable to creating the I.P. This treatment allows the taxpayer to obtain a current tax benefit for the tax year during which the research and development ("R&D") costs were paid or incurred. The Code permits a current deduction under Code §162 for all the ordinary and necessary expenses paid or incurred during the tax year in any trade or business. To be deductible under Code §162, a business expense must not be subject to a provision of the Code that requires capitalization, such as Code §263 or Code §263A.

If the Code requires that the costs incurred by a taxpayer in the creation of I.P. must be capitalized, the capitalized costs will form the taxpayer's basis in the I.P. However, if the costs may be deducted under the Code when and as incurred, the accelerated tax benefit prevents the expenditure from being part of the taxpayer's basis in the I.P. Consequently, a taxpayer may have zero basis in self-created I.P. if all the costs incurred in creating the asset were deducted.

Case law and Code §263 require the capitalization of a business expense if that expense will create or enhance a separate and distinct intangible asset, or create or enhance a future benefit beyond the tax year in which the expense is incurred.

The Regulations under Code §263 generally require that amounts paid to create or acquire an intangible asset must be capitalized.3 Amounts paid to facilitate the creation or acquisition of an intangible asset also must be capitalized.4 The regulations list some of the costs related to self-created intangible assets that must be capitalized. The most significant in the context of I.P. are (i) costs incurred to obtain rights from a governmental agency, such as costs to obtain, renew, renegotiate, or upgrade rights under a trademark, trade name, or copyright and (ii) costs to defend or perfect title to an intangible asset, such as the cost to settle a patent infringement lawsuit.5

Code §263A requires the capitalization of a variety of costs attributable to property produced by a taxpayer or acquired for resale in a trade or business or an activity conducted for profit. For the purposes of Code §263A, "property" is defined to include tangible property, which would seem to exclude I.P. However, tangible property under Code §263A includes films, sound recordings, videotapes, books, and similar property that is intended to be produced on a tangible medium and mass distributed in a form that is not substantially altered. Thus, for example, the cost of writing a book, including the cost of producing a manuscript and obtaining a copyright or license for the project, must be capitalized pursuant to Code §263A.

Research Expenses

Code §174 provides a current deduction for certain types of research and experimental ("R&E") expenses. Under this section, a taxpayer may elect to (i) currently deduct all R&E expenses made in connection with the taxpayer's trade or business or (ii) amortize the expenditures over a period of not less than 60 months beginning with the month in which the taxpayer first realizes benefits from the expenditures. For taxpayers operating at a loss, the deferral of the 60-month amortization period may provide a more valuable tax benefit. If neither election is made, the expenditures are merely capitalized into the basis of the I.P., eliminating any tax benefit until the I.P. is sold.

Code §174 actually applies more broadly than Code §162 because it is available to taxpayers who are not yet engaged in a trade or business. R&E expenses must be R&D costs in the experimental or laboratory sense - that is, activities intended to discover information that would eliminate uncertainty concerning the development or improvement of a product. Thus, for example, the cost of creating a patentable pharmaceutical product may be currently deducted under Code §174.

Startup Expenses

Many I.P. companies are "startups," working on developing and testing a new I.P. asset, with the hope that it will soon attract investors and customers. Expenses related to starting a new business generally are not deductible under Code §162 because the taxpayer is not yet engaged in carrying on a trade or business. Code §195 allows taxpayers to elect to defer deducting certain expenses incurred before the business becomes active and to deduct such expenses over a 15-year period beginning with the month in which the active business begins. Startup expenses are limited to costs that would be deductible if the business was already an active trade or business.

Amortization

Self-created I.P. used in a trade or business or held for the production of income may qualify for an amortization deduction under Code §167. The amount subject to the amortization deduction is the taxpayer's basis in the property. As discussed above, a taxpayer may not have a basis in self-created I.P. because the costs incurred to create the asset were currently deductible. The amortization deduction for self-created I.P. is available in cases in which a taxpayer was required to amortize the costs incurred in creating the I.P.

Code §167

The regulations state that if an intangible asset is known from experience or other factors to be of use in the business or in the production of income for only a limited period, which can be estimated with reasonable accuracy, the intangible asset may be amortizable under Code §167. The regulations specifically state that patents and copyrights have a useful life that can be reasonably estimated.6 In contrast, trade secrets and know-how generally have been held to not have limited useful lives because they remain valuable as long as they remain confidential.

The issues of (i) whether certain intangible assets have useful lives and (ii) the lengths of the useful lives of certain intangible assets have been the subjects of controversy. The regulations under Code §167 created some certainty by providing a safe harbor for certain intangible assets.

Under the safe harbor, a taxpayer may treat an intangible asset as having a useful life of 15 years, unless (i) another useful life is specifically prescribed or prohibited under the tax law, (ii) the intangible asset is acquired from another person or is a financial interest, (iii) the intangible asset has a useful life that can be reasonably estimated, or (iv) the intangible asset relates to certain benefits arising from real property.7 The basis of an intangible asset subject to the safe harbor must be amortized ratably over the 15-year period.8

Code §197

Code §197 generally applies to acquired intangible assets, typically in connection with the acquisition of a business as part of an asset purchase transaction. However, it also applies to a limited class of self-created intangible assets that are not part of an acquisition of a business. The class of self-created assets includes trademarks and trade names.9 Thus, to the extent that costs incurred to create such assets must be capitalized under general tax principles, Code §197 will apply to determine the period over which the capitalized costs will be amortized for income tax purposes.

TAX CONSIDERATIONS OF ACQUIRED I.P.

Basis

In General

Generally, a taxpayer's basis in an acquired asset, including an intangible asset, will be the amount paid for the asset. In an arm's length transaction, the amount paid should be the acquired asset's fair market value as determined in an independent transaction. If a taxpayer acquires a single asset, the basis of that asset will be the purchase price. If the taxpayer acquires multiple assets from a seller or a trade or business, the acquirer and the seller might not have...