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The Tax Implications of IP Settlements
Taxand USA discusses an example of tax treatment in a settlement agreement.
Company A brings a lawsuit against Company Z for trademark infringement. Company A wins and, as part of the settlement agreement, agrees to acquire the registered marks owned by Company Z and pays Company Z a sum of $10 million. In return, Company Z agrees to transfer its registered marks to Company A, to dismiss the lawsuit and to release all related claims against Company A.
Company A has a couple of alternatives for treating the settlement payment and other legal fees incurred in this trademark litigation. It could treat the total payment as an acquisition of the registered marks owned by Company Z. Costs incurred for the acquisition of an asset, or settlement amounts and other litigation costs incurred to defend or perfect title to an asset, are capitalised, regardless of the primary purpose of the taxpayer in making the payment.
Alternatively, Company A could treat a portion of the total payment as a royalty payment or damages for past infringement, with the balance attributable to the acquisition of the registered marks owned by Company Z. Company A cannot logically treat all of the payment as damages for past infringement, as such a position implies that the infringed IP owned by Company Z has significant value.
For many plaintiffs, the preferred alternative may be to maximise the amount of tax-free recovery or capital gain realised from the settlement. Such an alternative is especially attractive if the capital gain is subject to a lower tax rate, eg if Company Z is classified as a pass-through entity for federal income tax purposes and the capital gain will flow though to individual owners. Even if Company Z is a C corporation and does not qualify for any preferential tax rate on capital gain, a characterisation as capital gain may be beneficial if Company Z has capital loss carryovers, which can be used only to offset capital gain.
Discover more: The tax implications of IP settlements
Companies involved in IP litigation need to consider tax issues throughout the litigation and settlement process in order to support the maximum net after-tax recovery, or to minimise the net after-tax cost of any payments and expenses. It is too late to wait until after the settlement agreement is signed and the ink is dry to think about the applicable tax considerations.