What Did We Just Acquire? An Introduction to the Taxation of Acquired Intangibles | Gray Reed
In addition to being developed in-house, intellectual property (“IP”) can obviously be acquired from third parties. IP acquisitions may be more germane now than in the recent past as developers race to create and monetize artificial intelligence (“AI”) tools. But, while AI platforms might be the shiniest and most interesting objects in the current IP arena, acquirers still have to deal with much older (and mundane) tax questions like: (i) what is being acquired and (ii) how is its cost recovered? This post explores general federal income tax[1] principles applicable to the acquisition of software and other IP as well as corresponding tax efficiencies (or inefficiencies) that may exist based on the nature of the acquisition. This post also recognizes that the Code and its regulations do not address many modern digital assets in a complete manner. For instance, the tax treatment of domain names, virtual currencies, bot platforms, and non-fungible tokens remains a work in progress.[2]
The Purchase of Intellectual Property
IP can be acquired (x) as part of acquisitions comprising a trade or business or (y) separately or in groups of assets which do not constitute a trade or business. The deductibility of IP acquisition costs depends on the types of IP acquired and the manner of acquisition. The starting point for IP acquisitions is Treas. Reg. § 1.263(a)-4(b)(i) which simply refers the taxpayer to Treas. Reg. § 1.263(a)-4(c). The foregoing regulation lists fifteen types of intangibles that are capitalized by the purchaser. Careful readers will note that Treas. Reg. § 1.263(a)-4(b) includes a general “facilitation” clause that applies to both IP development (in-house costs) and IP acquisitions.[3] Therefore amounts paid to investigate or pursue IP acquisitions are also capitalized.[4] There are simplifying conventions. Employee compensation (partner guaranteed payments and director fees for regular – not special – board meetings are compensation for this purpose),[5] general overhead,[6] and “de minimis” ($5,000 or less) costs[7] related to IP acquisitions can often be expensed. The de minimis rule is per transaction, except that a taxpayer that reasonably expects to enter at least 25 similar transactions in a tax year can pool similar transactions for investigative cost efficiencies.[8] Special rules apply to pooling de minimis costs.[9]
Since capitalization is typically prescribed for IP acquisitions, the period of cost recovery becomes important. If IP is acquired as part of a trade or business acquisition (or an activity described in § 212)[10] the assets are typically “amortizable section 197 intangibles” eligible for 15-year amortization deductions.[11] In many, if not most, cases it is obvious when a trade or business is being acquired (i.e. buyer purchases all of the assets of a transportation company). In those cases all of a target’s assets are subject to a § 1060 allocation, with IP simply being allocated a portion of the purchase price and essentially amortized over 15 years pursuant to § 197. Status as an “amortizable section 197 intangible” matters for several other reasons:
- Partial Dispositions. If a buyer ends up disposing of any “amortizable section 197 intangible” but other such intangibles are retained (i.e. partial disposition of intangibles), no loss will be recognized on the disposition (or even worthlessness and abandonment).[12] Instead the taxpayer’s basis in retained § 197 intangibles is increased pro rata by the amount of the disallowed loss.[13]
- Nonrecognition Transfers. If a taxpayer acquires § 197 intangibles in the acquisition of a trade or business and then transfers select intangibles to a controlled corporation or partnership in a nonrecognition transaction where the intangible takes a transferred basis, the transferee continues to amortize the transferred intangibles on the same basis as the transferor’s remaining 15-year amortization period.
- Covenants Not to Compete. If a covenant not to compete or any other arrangement having substantially the same effect is entered into in connection with the direct or indirect acquisition of an interest in one or more trades or businesses (i.e. such a covenant is an amortizable section 197 intangible), the disposition or worthlessness of the covenant will not be deemed to occur until the disposition or worthlessness of all the acquirer’s interests in those trades or businesses.[14] As an example, assume Tom purchases 100% of Corporation’s assets from Jerry in 2020. As part of the acquisition, Jerry agrees not to compete with Tom for 5 years within a specific area. Three years after the acquisition, in 2023, Jerry violates the covenant (which is now worthless). In 2025 Tom sells all of the business to James. Even though the covenant was worthless in 2023, disposition of the covenant is not deemed to occur until 2025 when Tom sells the business. Until that date, Tom continues to amortize the covenant over 15 years.
- Partnerships and Common Control. Special rules apply to certain partnership transactions and transactions involving taxpayers under common control which are well beyond the scope of this post.[15]
Occasionally, however IP is acquired separately or in smaller groups, and § 197 does not apply to “certain interests or rights acquired separately”.[16] That would include separately acquired IP like certain software, films, sound recordings, books, patents, or copyrights.[17] Note that trade secrets, trademarks, know-how, and trade names are not in the foregoing list and are therefore subject to 15-year amortization regardless of whether acquired separately or as part of a trade or business. Guidance suggests that non-generic domain names that function as trademarks are also always 15 year § 197 intangibles.[18]
Interestingly, the Treasury Regulations in some cases treat the purchase of a single piece of IP as a trade or business acquisition. Specifically, the “acquisition of a franchise, trademark, or trade name constitutes the acquisition of a trade or business or a substantial portion thereof” because those items are heavily linked to going concern value.[19] There are exceptions for nominally valued and other items.[20] See however, PLR 200416002 where the IRS concluded the acquisition of patents and trademarks were not subject to § 197 but were instead amortizable under § 167(f). In other words, taxpayers purchasing IP outside of a classic M&A transaction should be thoughtful and ask, “did we just buy a business?”
Assets not covered by § 197 need to consider § 167. In fact, the § 167 regulations specifically provide amortization rules for intangibles not covered by § 197.[21] Because the § 167 regime allows different recovery periods and different computations (straight-line, income forecast method, etc.), this post merely mentions that taxpayers should review these rules thoroughly.
Wait…What Did We Just Acquire?
Finally acquirers always need to know if for tax purposes they have executed a purchase or merely acquired a license. At first glance, a license acquired as part of a trade or business is subject to § 197. Treasury Regulations § 1.197-2(b)(11) reads “
Section 197 intangibles include any right under a license, contract, or other arrangement providing for the use of property that would be a section 197 intangible under any provision of this paragraph (b) (including this paragraph (b)(11)) after giving effect to all of the exceptions provided in paragraph (c) of this section. Section 197 intangibles also include any term interest (whether outright or in trust) in such property.
The foregoing regulation indicates royalty payments are capitalized and amortized under the general § 197 rules whenever such a license is acquired in a trade or business acquisition. But exceptions often apply that allow current deductions for license (royalty) payments under § 162 instead of 15 year amortization under § 197. First, royalty payments for patents, copyrights, formulas, processes, designs, know-how, and other items (see Treas. Reg. § 1.197-2(b)(4) and (5) for the complete list) do not have to be capitalized if the taxpayer can establish § 1235 does not apply to the acquisition and the transfer was in a commercial arms’ length deal.[22] Next contingent payments for trademarks and tradenames can sometimes qualify for current deductions under § 1253. For consistency and symmetry the seller or licensor (and by extension the IRS) will care a great deal about the acquirer’s (or licensee’s) tax treatment of these payments because royalty income is typically taxed at ordinary rates while gains on sales can achieve capital gain rates.
Finally it can be difficult to distinguish between sales and licenses. Simplistically a transfer requires all substantial rights of an asset to be assigned to the acquirer. However, modern commercial agreements can be quite complex. Some agreements might provide quasi-exclusive rights, bespoke payment terms, reversionary rights, and other sophisticated components. There may also be a difference between what constitutes a transfer for federal income tax purposes versus local law. As such it is worthwhile to consult both tax and IP professionals for high dollar transactions.
[1] All “§” references are to specific sections of the Internal Revenue Code (the “Code”) unless otherwise noted.
[2] This includes income sourcing under §§ 861 et seq. in addition to general characterization concerns.
[3] Treas. Reg. § 1.263(a)-4(b)(1)(v).
[4] Id. See also Treas. Reg. § 1.263(a)-4(e).
[5] Treas. Reg. § 1.1263(a)-4(e)(4)(ii)(A), (B).
[6] Treas. Reg. § 1.1263(a)-4(e)(4)(i).
[7] Treas. Reg. § 1.1263(a)-4(e)(4)(iii).
[8] Treas. Reg. § 1.1263(a)-4(e)(4)(iii).
[9] Treas. Reg. § 1.1263(a)-4(h).
[10] This post does not discuss § 212 or the anti-churning rules in § 197. In other words, this post assumes the rules of § 197(c) and (f)(9) do not apply to transactions described herein.
[11] § 197(a), (b), (c)(1). Treas. Reg. § 1.197-2(b), -2(c).
[12] § 197(f)(1).
[13] This rule prevents a taxpayer from accelerating (reducing) the 15-year amortization period by partial dispositions of IP.
[14] § 197(f)(1)(B). Treas. Reg. § 1.197-2(g)(1)(iii).
[15] See, e.g., Treas. Reg. § 1.197-2(g).
[16] § 197(e)(4).
[17] § 197(e)(4).
[18] See CCA 201543014. This CCA assumes that the domain names are acquired from an operational site.
[19] Treas. Reg. § 1.197-2(e)(2)(i).
[20] Treas. Reg. § 1.197-2(e)(2)(A)-(C).
[21] Treas. Reg. § 1.167(a)-14.
[22] Treas. Reg. § 1.197-2(f)(3)(ii) and Treas. Reg. § 1.197-2(b).
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