Treasury Solicits Input On Taxation of Cross-Licensing Arrangements

International Tax Alert

The IRS and the Treasury Department have formally solicited input regarding the treatment of cross-licensing arrangements (“CLAs”) for tax purposes, and in particular whether such arrangements give rise to imputed royalties that would be subject for the first time to withholding taxes. Although this issue has been considered for some time in various contexts, the formal solicitation of input strongly suggests that the IRS intends to issue regulatory or other guidance with respect to CLAs. In light of this, companies with substantial intellectual property rights are encouraged to consider responding to the IRS to ensure that their CLAs are treated appropriately and to consider carefully the tax ramifications of any CLA in the future.


A CLA is a reciprocal contract between two intellectual property (typically patent) owners under which each party grants to the other a limited license with respect to intellectual property. A CLA is typically an agreement between the parties not to sue one another for possible intellectual property infringement; it is often negotiated in the context of settlements of potential intellectual property disputes. The parties typically do not pay one other under the arrangement, although occasionally one party makes a balancing payment to even out perceived inequalities in the arrangement.

CLAs allow companies to develop their intellectual property without the constant threat of lawsuits from competitors. With this enhanced “freedom to operate,” companies are better able to advance and exploit their own technology. Under the current U.S. tax law, CLAs do not give rise to imputed cross payments or otherwise produce any tax obligations unless an actual balancing payment is made, in which case that cash payment is treated as royalty income. See PLR 7739073 (July 1, 1977). This longstanding tax treatment is consistent with the tax treatment of CLAs in foreign jurisdictions.

IRS Activity Notice 2006-34

The IRS has been reconsidering its treatment of CLAs and in particular whether they give rise to an imputed payment that would be subject to withholding tax in the context of specific company audits. Taxpayers have vigorously opposed IRS efforts to change its treatment of CLAs through the audit process. On March 15, 2006, the IRS and the Treasury Department issued Notice 2006-34, soliciting information regarding CLAs. This formal request for industry input strongly indicates that the IRS and Treasury may promulgate regulations.

The IRS is focusing on whether to treat some or all CLAs as giving rise to imputed income and expenses, thereby giving rise to withholding taxes in the case of cross-border arrangements. The IRS has indicated that the tax treatment of CLAs will depend on whether they are best characterized as: (1) a two-way license of intellectual property rights, (2) a reciprocal agreement not to assert any claims of infringement, or (3) a sale or exchange of property. Accordingly, much of the information it seeks in the notice is targeted towards determining the best characterization. The general categories in which the IRS seeks information include: 

  1. Business circumstances in which cross licensing arises;
  2. Distinguishing among different CLAs;
  3. Sourcing the income from cross licensing;
  4. Valuation of cross licensed rights;
  5. Financial accounting treatment of cross licensing; and
  6. Foreign tax treatment of cross licensing.

Ramifications of Notice 2006-34

The most significant issue identified by the IRS is whether a U.S. person that is party to a cross-border CLA should be treated as incurring withholding tax obligations on non-cash imputed payments to the foreign counterparty. It is possible that the IRS would apply this new, onerous treatment retroactively to all open taxable years.

The treatment of CLAs as giving rise to imputed royalty payments subject to withholding taxes would have numerous negative consequences. First and foremost, the imposition of such a tax may give rise to double taxation and would have an adverse effect on the international competitiveness of U.S. companies. For financial accounting purposes, U.S. companies might need to disclose their potential liability for withholding tax from income imputed to CLAs and set aside a corresponding reserve. This requirement would present an uneven obligation in that foreign jurisdictions do not impose a similar withholding obligation. In addition, if U.S. companies were to insist that foreign companies bear the withholding tax liability, the former would likely find it more difficult to enter into CLAs.

From an administrative perspective, it would be difficult (and likely imprecise) for U.S. companies to value the gross benefits of CLAs. U.S. companies would incur valuation and other compliance costs, thus reducing the amount they have available to invest in developing new technology.

U.S. companies would also face collections issues. With respect to prior taxable years, foreign parties to CLAs might not reimburse U.S. companies for withholding tax payments because existing CLAs generally do not provide a reimbursement procedure. Future years might also prove problematic in that U.S. parties to CLAs do not have control over any money or property of foreign parties to CLAs from which to draw withholding tax payments.

In addition to the withholding tax issues, there are sourcing and other issues that may arise because the character and source of any imputed royalty or other income may not match the character and source of the corresponding imputed royalty or other expense.

Recommended Response

Companies with substantial intellectual property rights should consider providing input to the IRS to encourage the IRS to maintain its longstanding tax treatment of CLAs. In addition, and depending on what if any regulatory guidance is issued, companies should consider carefully the tax ramifications for any future CLAs. In light of the potential adverse effects on the development of intellectual property and economic well-being of U.S. companies that have entered into CLAs, it is important for these companies to monitor developments in this area, to consider submitting comments to the IRS and Treasury, and to scrutinize future CLAs.

For further information, please contact any of the following lawyers:

Rocco Femia,, 202-626-5823

Kimberly Majure

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