By Kimberly S. Blanchard, Esq.
Weil, Gotshal & Manges LLP, New York, NY
For most purposes of the Code, rents and royalties are accorded parallel tax treatment. Rents are to tangible property (e.g., equipment) what royalties are to intangible property (e.g., a patent), i.e., consideration paid by a non-owner to an owner for the right to use property. In the recipient's hands, both rents and royalties are ordinary income. With exceptions described herein, both rents and royalties are "fixed or determinable annual or periodical" (FDAP) income and, under the Code, subject to a 30% tax when U.S.-source and paid to a foreign owner, unless effectively connected with the conduct of a U.S. trade or business.
The tax law has long struggled to distinguish a lease or a license from a conditional sale. In each case, the question comes down to whether the person who in form is labeled the lessee or licensee is in substance the tax owner of the underlying property. To make this distinction, the tax law looks to who, taking into account all relevant facts and circumstances, bears the burdens and reaps the benefits of ownership.
Rev. Rul. 55-5401 describes the factors that distinguish a lease from a conditional sale. One important factor is the term of the lease; the longer the term, the more likely it is that the lease is in substance a sale. Another factor is whether rental payments are at fair rental value, or instead include a disguised interest component. If the lessee has an option to acquire title to the property at less than full fair market value, this is a strong factor weighing toward sale treatment.
There is no counterpart to Rev. Rul. 55-540 for licenses of intangible property. This may be due to the difficulty of discerning the useful life or fair license value of intangible property, which is often unique. In Rev. Rul. 54-409,2 the IRS took the view that if intangible property were transferred for a series of payments "contingent on the productivity, use or disposition" of the property (hereafter, "CPU payments"), the transfer could not be characterized as a sale for tax purposes. However, it later reconsidered, and in Rev. Rul. 60-2263 abandoned any attempt to draw the line between a license and a sale based solely on the form of the payments received.
Today, the distinction between a true license and a sale of intangible property is generally considered to turn upon whether the transferor has transferred all substantial rights to the intangible property. At one extreme, a transfer of the worldwide, unrestricted, perpetual, and exclusive right to make, use, and sell products using the intangible property is clearly a sale. At the opposite extreme, a transfer of a limited-scope, nonexclusive right to use the property for a particular purpose for a limited period of time would not be treated as a sale. The difficulty, of course, is that most cases fall somewhere between these two extremes.
The cross-border treatment of rents is quite clear. Rents are sourced to the place where the tangible property is located and used. Because the location of tangible property is easy to pinpoint, the State of that location (the source State) generally has clear jurisdiction to tax rents from the property and may do so on a gross or net basis, usually depending upon whether the property is held in connection with a business. Treaties do not generally provide benefits for rental income.4 If such income is not connected with a business, it may therefore be subject to withholding tax at source. If it is connected with a business, it is generally taxable by the source State only if the nonresident taxpayer has a permanent establishment there to which the rent is attributable. If a lease is treated for U.S. tax purposes as a sale, the gain is generally not recharacterized under U.S. tax law or under treaties, even if the payments of purchase price take the form of CPU payments over time. Because the United States does not tax a non-U.S. person's gains from a sale of property (except U.S. real property), a lease properly treated as a sale would attract no U.S. tax in most cases.
One might suppose that a sale of intangible property would also be respected in the cross-border context. In fact, this is not the case. Our cross-border tax rules applicable to royalties appear to be stuck in a 1950s' time warp. Both §871(a)(1)(D) and §881(a)(4) contain a special rule applicable to sales of intangible property by foreign persons. If such property is used in the United States and is sold for a series of CPU payments, the foreign seller's gain is transformed into FDAP income that is U.S.-source (because the property is used in the United States) and, unless the income is effectively connected with the conduct of a U.S. trade or business, it is subject to U.S. withholding tax as if it were a royalty. That is, the law as interpreted by the IRS in Rev. Rul. 54-409 governs as if that ruling had never been modified by Rev. Rul. 60-226. Thus, form governs: If a foreign owner of intangible property sells the property for a series of CPU payments, his gain will often be treated as ordinary FDAP income and the payments will be treated as royalties. If instead the foreign owner sells the intangible property for a lump sum, his gain will ordinarily be capital gain exempt from U.S. taxation altogether.5
Most U.S. tax treaties mirror this unusual rule. Article 12(2)(b) of the 2006 U.S. Model Income Tax Treaty defines "royalties" to include "gain derived from the alienation of any [intangible property], to the extent that such gain is contingent on the productivity, use, or disposition of the property." The Technical Explanation to the U.S. Model contains no explanation for this rule. It does note, in the explanation of Article 13 covering gains, that whether payments on the disposition of intangible property are covered by Article 12 or by Article 13, such payments would be taxed only in the seller's home country. But this statement is true only under treaties that, like the U.S. Model, exempt royalties from source-based withholding tax. Several of our tax treaties do not.
The result of these rules is to impose a U.S. withholding tax, at the rate of 30% unless reduced under the royalties article of a treaty, on U.S.-source CPU payments arising upon the sale of intangible property by a foreign person. This is an extraordinarily harsh and uneconomic result. The sale of property is a basis recovery event; the seller's gain, if there is a gain, is computed by subtracting his basis from the gross proceeds (here, the sum of all CPU payments and any other payments under the sale). A sale for an amount less than basis will produce a loss, but under these rules there could be a 30% withholding tax on gross proceeds even in the case of an economic loss. The imposition of such a tax would appear to violate all known income tax precepts.
This result is even more astonishing when one considers that the United States does not purport to tax the gains of foreign sellers, except on the sale of U.S. real property. The rules just described apply only to what everyone agrees is a sale or disposition of property. To go from a zero-basis tax to a 30% tax based merely on form is simply remarkable. One searches in vain for any justification for such a rule.
It may be posited that a foreign person can avoid these harsh rules if the gain from the sale of the intangible property is effectively connected with a U.S. business (or qualifies as business profits attributable to a U.S. permanent establishment under a treaty). It is hard to understand, however, why a one-time inventor or even a passive investor in intangible property should be subject to such potentially confiscatory taxation. Moreover, at least as applied to individuals, the U.S. tax rules are, in one set of cases, facially discriminatory. Section 1235 of the Code permits a U.S. individual inventor, who in most cases would not be engaged in a business, to treat as capital gain CPU payments for all substantial rights to a patent, or an undivided interest therein which includes a part of all such rights, even if the underlying transfer would not otherwise be treated as a sale. When §1235 was enacted, Congress explicitly enacted the opposite rule for foreign individuals (which has since been replaced by §871(a)(1)(D)).6
What about U.S. taxpayers who sell intangible property? Our treaties can result in such taxpayers becoming subject to foreign tax on what U.S. law would generally regard as U.S.-source capital gain. For this reason, §865(d) contains a special sourcing rule. It provides that, on a sale of intangible property for CPU payments, the source of the gain is the same it would have been had such payments constituted royalties. Thus, if a U.S. seller is trapped by a similar foreign rule, its gain will be re-sourced for U.S. income tax purposes so that the U.S. seller should generally be entitled to claim a foreign tax credit for the foreign taxes levied on the CPU payments.
This commentary also will appear in the January 2013 issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see Blessing and Lubkin, 905 T.M., Source of Income Rules, Bissell, 907 T.M., U.S. Income Taxation of Nonresident Alien Individuals, Katz, Plambeck, and Ring, 908 T.M., U.S. Income Taxation of Foreign Corporations, Tello, 915 T.M.,, Payments Directed Outside the United States - Withholding and Reporting Provisions Under Chapters 3 and 4, and in Tax Practice Series, see ¶7120, Foreign Persons - Gross Basis Taxation, ¶7130, Foreign Persons - Effectively Connected Income, ¶7150, U.S. Persons - Worldwide Taxation, ¶7160, U.S. Income Tax Treaties, and ¶7170, U.S. International Withholding and Reporting Requirements.
1 1955-2 C.B. 39.
2 1954-2 C.B. 174.
3 1960-1 C.B. 26.
4 One exception: Tax treaties often provide special rules for transportation income, which by its nature is hard to pin down to one place, and such provisions may cover rented property.
5 If the intangible property had been used in connection with a U.S. trade or business, gain upon its sale can be taxed as effectively connected income.