Note: This memo discusses the sourcing rules for intellectual property created by a foreign person, but used in the U.S. It also discusses the sourcing of settlement proceeds paid by a U.S. infringer to the foreign inventor.  This memo addresses the U.S. tax consequences when a foreign person sues a U.S. company for violating the foreign person's intellectual property (in this case, a copyright) and the foreign person receives settlement proceeds.

I. FACTS:

Client and Foreign Partner (collectively "plaintiffs") settled a lawsuit against Software, Inc. and John Doe (collectively "defendants") for copyright infringement of a software program known as "A TO Z." A TO Z was developed in a foreign country by Foreign Partner. As part of the settlement, plaintiffs granted defendants "an irrevocable, exclusive, fully paid perpetual worldwide license to use the name or mark ‘A TO Z’ within the name or mark ‘WIN A TO Z’." Further, plaintiffs released and disclaimed "any interest whatsoever in the name or mark ‘A TO Z’ " and forever released and disclaimed "any claim that the name or mark ‘A TO Z’ infringes on any trademark or tradename rights" that might be held by defendants.

In addition, as part of the settlement, plaintiffs granted defendants "an irrevocable, non-exclusive, fully paid, perpetual worldwide license to versions 22 through and including 22.6 of the A TO Z source code.

A TO Z Partners was a general partnership between Client and Foreign Partner. Foreign Partner invented the A TO Z source code and executed the license that caused the claim of trademark infringement. The partnership had applied for a trademark on the name A TO Z. As part of the settlement, defendants received a non-exclusive license to the source code, which is now obsolete and full and complete rights to the trademark "A TO Z." The partnership was based in a foreign country, the domicile of the inventing partner Foreign Partner. Ownership was 51% Foreign Partner and 49% Client, but the proceeds from the lawsuit were to be divided as mutually agreed, in proportion to the work performed to create and license the software.

1. Who owned the rights to the A TO Z trademark and software code?

2. Are the settlement proceeds characterized as the sale of an asset or payments of a royalty?

3. Is the source of payment U.S. or foreign source?

a. Was the partnership a U.S. or foreign partnership?

b. Was the partnership engaged in a trade or business in the U.S. through a fixed place of business?

4. Are the payments to Foreign Partner subject to U.S. taxation and withholding?

a. If the payments are subject to withholding, who is the withholding agent?

5. How are the proceeds from the settlement to be allocated among the plaintiffs?

A. Foreign Partner owned the tradename and source code since he was the inventor of the code and licensed the code and name. He never legally transferred the source code or tradename to any other party.

B. The payment for the tradename and source code was for a sale of the asset, rather than a payment of royalties, since full right, title and interest passed to the purchaser and plaintiffs retained no significant rights.

C. The source of payment is foreign. A foreign person owned the tradename and source code and settled a lawsuit regarding infringement of his property. Settlement payments follow the source of the damages. In this case, a straight payment for this property would have been foreign source, since Foreign Partner was not engaged in business in the U.S. and was a non-resident alien.

D. The payments to Foreign Partner are not subject to U.S. taxation or withholding.

E. If the settlement proceeds are considered U.S. source, then the person with custody and control over the settlement proceeds is the withholding agent.

F. The proceeds should be allocated pursuant to a binding written agreement among the plaintiffs, and should reflect each plaintiff’s proportional claim of damages in the lawsuit.

A. Foreign Partner Owned the Source Code, Copyright of the Source Code and Tradename "A TO Z".

1. Source Code and Copyright:

As a matter of intellectual property law, the person inventing intellectual property is the owner under both U.S. and foreign country law, unless he transfer the rights to another party. In this case, Foreign Partner was the inventor and although he may have teamed up with Client to form a partnership to market his software, the rights to the software were never legally transferred to the partnership. Likewise, any transfer to a U.S. corporation of the software expressly excluded the rights to collect damages in the lawsuit.

2. Plaintiffs Sold, Rather than Licensed, the Tradename and Source Code to Defendants.

Although the wording of the settlement uses the term license, in reality, Plaintiffs parted with all rights, title and interest in and to the tradename and virtually all rights to the software code. The software code was obsolete and did not have much value, except to protect defendants in case they used part of the code in their   A TO Z software application.

In November 1996 the IRS issued proposed rules for classifying transactions involving the transfer of computer programs as sales, licenses, leases, or the provision of services or of know-how under certain Code provisions (including those for determining the source of income) and tax treaties. REG-251520-96, 61 Fed. Reg. 58152 (11/13/96). The source of income derived from these transactions would depend on the transactions' classification. For example, the proposed regulations would source transactions classified as sales under the rules applicable to sales of personal property; transactions classified as licenses or leases under the rules applicable to royalties or rents, respectively.

Prop. Regs. Section 1.861-18(a)(3) define the term computer program as a set of statements or instructions to be used directly or indirectly in a computer in order to bring about a certain result.

Under Prop. Regs. Section 1.861-18(b)(1), a transaction involving the transfer of a computer program would be classified as either:.

• the transfer of a copyright right in the computer program. Neither the form adopted by the parties to a transaction nor the classification of the transaction under copyright law is determinative for tax purposes. Regs. Section 1.861-18(g)(1).

• the transfer of a copy of the computer program (a copyrighted article); A copyrighted article is defined as a copy of a computer program from which the work can be perceived, reproduced, or otherwise communicated. Prop. Regs. Section 1.861-18(c)(3).

Prop. Regs. Section 1.861-18(c)(1)(i) and (2) classify the transfer of a computer program as the transfer of a copyright right if the transferee acquires one or more of the following rights:

• the right to make copies of the computer program for purposes of distribution to the public by sale or other transfer of ownership, or by rental, lease or lending;

• the right to prepare derivative computer programs based upon the copyrighted computer program;

• the right to make a public performance of the computer program; or

• the right to publicly display the computer program. A transfer that involves copyright rights is further classified as either a sale or a license of copyright rights. If, taking into account all the facts and circumstances, all substantial rights have passed to the transferee, the transfer constitutes a sale. If all substantial rights are not transferred, the transaction is classified as a license (which generates royalty income).

If a person acquires a copy of a computer program but does not acquire any of the rights described in the preceding paragraph, the transfer of the copy of the computer program is classified solely as a transfer of a copyrighted article. Prop. Regs. Section 1.861-18(c)(1)(ii).

A transfer that involves a copyrighted article is further classified as either a sale or a lease of a copyrighted article. Prop. Regs. Section 1.861-18(f)(2). See also Prop. Regs. Section 1.861-18(f)(3). If, taking into account all the facts and circumstances, the benefits and burdens of ownership have been transferred, then the transfer is treated as a sale. If insufficient benefits and burdens of ownership are transferred (so that the transferor is properly treated as the owner), then the transaction is classified as a lease (generating rental income).

Final regulations. T.D. 8785 (published on October 2, 1998 in 63 Fed. Reg. 52971) provides final regulations under Regs. Section 1.861-18 that characterize transactions involving computer programs. Generally, the final regulations adopt the provisions of the proposed regulations, as discussed below. However, the final regulations provide a number of important amendments to the proposed regulations in response to comments.

Source rules. First, the final regulations provide explicit source rules for income derived from computer program transactions. Income from the sale or exchange of copyrighted articles will be sourced under Sections 861(a)(6), 862(a)(6), 863, 865(a), 865(b), 865(c), and 865(e), as appropriate, whereas income derived from the lease of a copyrighted article will be sourced under either Section 861(a)(4) or 862(a)(4). Income derived from the sale or exchange of a copyright right will be sourced under Section 865(a), (c), (d), (e), or (h), as appropriate, whereas income derived from the license of a copyright right will be sourced under either Section 861(a)(4) or Section 862(a)(4).

Effective dates. The regulations are effective generally for transactions occurring under contracts entered into after November 30, 1998.

In the instant case, all right title and interest in and to the tradename was transferred to defendants under a "an irrevocable, exclusive, fully paid perpetual worldwide license to use the name or mark ‘A TO Z’ within the name or mark ‘WIN A TO Z’." The name A TO Z had no value to plaintiffs since  A TO Z was a major software developer and plaintiffs did not intend to market their software after the settlement.

3. The Copyright Transfer Was a Sale

General Rule--A transfer of a franchise, trademark, or trade name shall not be treated as a sale or exchange of a capital asset if the transferor retains any significant power, right, or continuing interest with respect to the subject matter of the franchise, trademark, or trade name. IRC Sec. 1253 provides as follows:

1253(a) General Rule.--

A transfer of a franchise, trademark, or trade name shall not be treated as a sale or exchange of a capital asset if the transferor retains any significant power, right, or continuing interest with respect to the subject matter of the franchise, trademark, or trade name.

1253(b) Definitions.--

For purposes of this section--

1253(b)(1) Franchise.--The term "franchise" includes an agreement which gives one of the parties to the agreement the right to distribute, sell, or provide goods, services, or facilities, within a specified area.

1253(b)(2) Significant power, right, or continuing interest.--The term "significant power, right, or continuing interest" includes, but is not limited to, the following rights with respect to the interest transferred:

1253(b)(2)(A) A right to disapprove any assignment of such interest, or any part thereof.

1253(b)(2)(B) A right to terminate at will.

1253(b)(2)(C) A right to prescribe the standards of quality of products used or sold, or of services furnished, and of the equipment and facilities used to promote such products or services.

1253(b)(2)(D) A right to require that the transferee sell or advertise only products or services of the transferor.

1253(b)(2)(E) A right to require that the transferee purchase substantially all of his supplies and equipment from the transferor.

1253(b)(2)(F) A right to payments contingent on the productivity, use, or disposition of the subject matter of the interest transferred, if such payments constitute a substantial element under the transfer agreement.

Thus, where a transferor receives for all the substantial rights into perpetuity only a fixed sum and no other right, power or continuing interest is retained, payments will constitute payments for a capital asset unless the trademark or franchise is held for sale to customers in the ordinary course of a trade or business. In the instant case, all right, title and interest in and to the trademark and tradename were irrevocably transferred to defendants; therefore, the transaction was a sale.

B. Even If the Transfer of the Trademark and Copyright Were Considered Royalties, the Payments are Foreign Source

A transaction that does not constitute a sale or exchange because not all substantial rights have been transferred will be classified as a license generating royalty income. Income derived from the licensing of a copyright will be sourced, according to Regs. Section 1.861-18(f)(1), under Sections 861(a)(4) or 862(a)(4), as appropriate.

IRC Reg Sec. 1.861-18(f)(1) states as follows:

(1) Transfers Of Copyright Rights.

The determination of whether a transfer of a copyright right is a sale or exchange of property is made on the basis of whether, taking into account all facts and circumstances, there has been a transfer of all substantial rights in the copyright. A transaction that does not constitute a sale or exchange because not all substantial rights have been transferred will be classified as a license generating royalty income. For this purpose, the principles of sections 1222 and 1235 may be applied. Income derived from the sale or exchange of a copyright right will be sourced under section 865(a), (c), (d), (e), or (h), as appropriate. Income derived from the licensing of a copyright right will be sourced under section 861(a)(4) or 862(a)(4), as appropriate. (emphasis added)

IRC Sec. 862(a) (4) states as follows:

(a) Gross Income From Sources Without United States

The following items of gross income shall be treated as income from sources without the United States:

(4) rentals or royalties from property located without the United States or from any interest in such property, including rentals or royalties for the use of or for the privilege of using without the United States patents, copyrights, secret processes and formulas, good will, trade-marks, trade brands, franchises, and other like properties. (emphasis added)

Consequently, even if the payments are considered royalties from the licensing of a copyright for computer software, the payments are foreign source since Foreign Partner created them and owned them in a foreign country. The damages paid to him are also characterized as foreign source.

In the case of intangible property (i.e., trademarks, patents, etc.), the place-of-use test allocates royalties according to the place in which the licensee is legally entitled to use, and legally protected in using, the intangible property, assuming the property is actually used there.

In Rev. Rul. 68-443, 968-2 C.B. 304, the owner of the right to use a trademark outside the United States granted an exclusive license to a U.S. manufacturer, which affixed the trademark to goods sold in the United States for shipment to foreign customers. The ruling concluded that the place of use of the trademark was the place in which the products to which the trademark was affixed were used or consumed and not the place in which the trademark was affixed. Similarly, the IRS has ruled that royalties received by a nonresident alien author from a domestic corporation were foreign source where they related to property sold exclusively in a foreign country under the protection of such country's copyright law; the fact that the payor printed the books in the United States was not relevant. Rev. Rul. 72-232, 1972-1 C.B.

In the instant case, the place of use was a foreign country since the infringing defendants did not have the right to use the copyrighted software program in the U.S. and paid damages for their infringement of the foreign country’s copyright and trademark rights under foreign country law. Thus, the "use" of the copyright and trademark occurred in a foreign country and are sourced as foreign.

C. Damages Received in a U. S. Lawsuit are Sourced under the U.S. vs. Foreign Source Rules

If a transferor, whether a licensor or a seller, of a trademark or trade name receives payments for infringement, the payments have the same character as would payments from the transferee. Republic Automotive Parts, Inc. v. Comr., 68 T.C. 822 (1977), aff'd, 611 F.2d 645 (6th Cir. 1979). This result is consistent with the treatment of such payments for infringement of other types of intellectual property. Blake v. Comr., 67 T.C. 7 (1976). This "relation back" doctrine was articulated in Arrowsmith v. Comr., 344 U.S. 6 (1952).

In Rev. Rul. 83-177, 1263 the IRS ruled that, for purposes of determining the source of settlement payments, the nature of the item for which such payments are made governs with respect to that component of the payments which constitutes principal. The interest component of the payments must be sourced according to the source of interest rules.

In Rev. Rul. 83-177, a foreign partnership formed by two nonresident aliens entered into a joint venture agreement with a U.S. corporation for purposes of rendering engineering services for the construction of a manufacturing plant abroad. All of the services to be performed by the foreign partnership were to be performed abroad; hence, it would have earned foreign source income. Following the domestic corporation's repudiation of the agreement, the foreign partnership filed suit for breach of contract and a settlement was reached. The IRS ruled that, since the agreement giving rise to the action would have caused the partnership to receive foreign source service income, the payments of principal made under the settlement are also considered foreign source service income.

PLR 9623045 applied Rev. Rul. 83-177 principles to damages paid to foreign corporation in action against U.S. corporation for breach of franchise agreement.

D. The Character of the Damages as Capital Gains or Ordinary Income Follow the Origin of the Claim

The origin of the claim test plays a crucial role in determining the tax treatment of payments received (and payments made) pursuant to a judgment or settlement. The origin and nature of the underlying claim is examined to determine: (i) whether or not the payment is excludible from gross income; (ii) if the payment is not excludible, whether it is ordinary income or capital gain; (iii) whether or not the payment is deductible as trade or business or production of income expense; and (iv) whether the payment is deductible currently or whether it must be capitalized.

The origin and nature of the claim test was first applied by the U.S. Supreme Court in 1941 in Hort v. Comr., 313 U.S. 28 (1941) and later articulated in 1963 in U.S. v. Gilmore 22 372 U.S. 39 (1963).

The basic function of the origin and nature of the claim doctrine is to restore the plaintiff-taxpayer to the same position under the tax law that he would have occupied had the injury not occurred. This is accomplished by treating an amount received in satisfaction of a claim as a substitute for the item of loss or economic detriment alleged in the claim and assigning it the same tax treatment that the lost item would have received had the loss not occurred in the first place.

The nature and the character of the claim is examined to determine whether the recovery is includible as ordinary income or capital gain. For example, a claim for lost profits gives rise to ordinary income whereas a claim alleging harm to a capital asset gives rise to capital gain.

1. Allocation of Damages Among plaintiffs

As a general rule, when the settlement agreement allocates expressly the settlement proceeds among various claims such allocation is binding for tax purposes. Bagley v. Comr., 105 T.C. 396 (1995), aff'd, 121 F.3d 393 (8th Cir. 1997) However, to be respected, allocations in a settlement agreement must be arrived at in an adversial context at arm's length and in good faith. Mitchell v. Comr., T.C. Memo 1990-617, aff'd, 992 F.2d 1219 (9th Cir. 1993). Although the cases cited here deal with allocation of type of damages paid to a single defendant, the same logic should apply to the allocation of the amount of damages among various plaintiffs.

Quite often the interests of the parties to a settlement agreement are adverse. Consequently, express allocations are likely to be the result of an arm's-length and adversarial negotiation process. If the intent of the payor cannot be discerned from the settlement agreement, such intent must be discerned from all the facts and circumstances of the case. Factors to consider include the details surrounding the litigation in the underlying proceedings, the allegations contained in the payee's complaint, and the arguments made in the underlying proceeding by each party. Robinson v. Comr., 102 T.C. 116 (1994), aff'd, 70 F.3d 34 (5th Cir. 1995)

If the express language of the agreement does not provide any allocations, again the critical question is, in lieu of what was the settlement amount paid. Bagley v. Comr., Church v. Comr., 80 T.C. 1104 (1983) More appropriately the question is, what claim(s) of the taxpayer the settlement amount was intended to settle. The Second Circuit, in Agar v. Comr., 290 F.2d 283 (2d Cir. 1961), aff'g T.C. Memo 1960-21 stated that the ultimate inquiry should be to determine the basic reason why the payor made the payment regardless of the payee's belief why the payment was made. The Second Circuit's sentiment since has been affirmed by several courts. For example, in Stocks v. Comr., 98 T.C. 1 (1992, ) the Tax Court stated that if the settlement agreement lacks express language stating what the settlement amount was paid to settle, then the most important factor in determining any exclusion under Section 104(a)(2) is the intent of the payor as to the purpose in making the payment.

The intent of the payor must be discerned from all the facts and circumstances of the case. In Rev. Rul. 85-98, the IRS stated that it looks to the complaint as the most persuasive evidence of how to characterize the recovery. There the taxpayer, in a suit for libel, requested $150,000 in compensatory damages and $450,000 in punitive damages. The parties settled for a lump sum of $240,000. The IRS allocated the lump sum using the ratio of the amount of compensatory and punitive damages requested to the total damages requested. Thus, one-fourth of the $240,000 or $60,000 was allocated to compensatory damages and the balance (i.e., $180,000) was allocated to punitive damages.

In Robinson v. Comr., 102 T.C. 116 (1994), aff'd, 70 F.3d 34 (5th Cir. 1995), the court stated that where the payor's intent cannot be discerned from the settlement agreement, it must be determined from all facts and circumstances of the case. Factors to consider, the court continued, include the details surrounding the litigation in the underlying proceedings, the allegations contained in the payee's complaint in the underlying proceedings and the arguments made in the underlying proceedings by the parties.