SCOTUS Reports

Tag: Patent Sale vs. License

  • Rollman v. Commissioner, 25 T.C. 481 (1955): Distinguishing Patent Licenses from Sales for Tax Purposes

    25 T.C. 481 (1955)

    To qualify as a sale of a patent, the agreement must transfer all substantial rights of the patentee, including the right to make, use, and sell the invention.

    Summary

    The United States Tax Court addressed whether payments received by a partnership from a licensing agreement for patent rights constituted long-term capital gain from a sale or ordinary income from royalties. The court found that because the agreement did not transfer all substantial rights of the patentee, it was a license, and the payments were ordinary income. The court also determined the basis for depreciation of patents, allowing depreciation based on the cost of machinery and payments for patent acquisition, despite the loss of original records. The case underscores the importance of transferring all patent rights, specifically the right to make, use, and vend, to achieve capital gains treatment for tax purposes.

    Facts

    The Rollmans, a partnership, owned the Rajeh patent for a rubber footwear process. The partnership entered into an agreement with Rikol, Inc., granting Rikol an “exclusive license” to manufacture and sell shoes under the patent. The agreement also granted Rikol the right to sublicense to corporations controlled by Leo Weill but did not include the right to use the process. Rikol subsequently entered into a sublicense agreement with Wellco Shoe Corporation, also controlled by Leo Weill. The Rollmans received payments from Wellco in 1947, 1948, and 1949. The Rollmans claimed these payments as long-term capital gains on their tax returns. Additionally, the Rollmans sought depreciation deductions on the Rajeh patent, as well as on two other patents, Paraflex and Snow Boot.

    Procedural History

    The Commissioner of Internal Revenue determined deficiencies in the Rollmans’ federal income taxes for 1947, 1948, and 1949, reclassifying the payments from Rikol as ordinary income. The Commissioner also disallowed the depreciation deductions claimed by the Rollmans. The Rollmans petitioned the United States Tax Court, challenging the reclassification of income and the disallowance of depreciation deductions. The Tax Court consolidated the cases of the Rollman partners.

    Issue(s)

    1. Whether payments received by The Rollmans from Rikol pursuant to a written agreement in respect to patent rights constitute long-term capital gain from the sale of a capital asset or ordinary income (royalties) from a licensing agreement.

    2. To what extent, if any, the partnership is entitled to a deduction for depreciation on the Rajeh, Paraflex, and Snow Boot patents.

    Holding

    1. No, because the agreement only granted an exclusive license to manufacture and sell, not the right to use, the payments are considered ordinary income (royalties), not capital gains.

    2. Yes, a depreciation deduction is allowed on the Rajeh and Paraflex patents, but the claimed depreciation on the Snow Boot patent was disallowed as it exceeded its established basis.

    Court’s Reasoning

    The court focused on whether the agreement between the Rollmans and Rikol constituted a sale or a license of the Rajeh patent. The court relied on the Supreme Court case, *Waterman v. MacKenzie*, which established that a transfer must include the exclusive right to make, use, and vend to be considered a sale. The agreement in this case only granted the right to manufacture and sell, not to use, the patented process. Because Rikol couldn’t permit others to use the process, the court held that all substantial rights were not transferred, and the agreement was a license. The court emphasized, “the agreement must effect a transfer of all of the substantial rights of the patentee under the patent in order to constitute a sale for Federal income tax purposes.”

    Concerning depreciation, the court found sufficient evidence to establish a basis for the Rajeh and Paraflex patents, despite the loss of the partnership’s original records. The court applied the *Cohan* rule, allowing a reasonable estimate of costs. However, since they had previously recovered an amount in excess of their basis, the court denied any additional depreciation allowance for the Snow Boot patent.

    Practical Implications

    This case is critical for tax planning involving intellectual property. It highlights that, for tax purposes, the characterization of a patent transfer as a sale or a license depends on the *legal effect* of the agreement, not its name. Attorneys should carefully draft patent transfer agreements to ensure that they convey all substantial rights, including the right to make, use, and sell, to qualify for capital gains treatment. Failing to do so will result in ordinary income treatment. The court’s decision provides a clear precedent for distinguishing between patent sales and licenses, especially when drafting or interpreting such agreements. It also reminds practitioners that, even with incomplete records, courts may allow a reasonable estimate of basis under certain circumstances. The decision also underscores the importance of accurately accounting for prior depreciation deductions.

  • Kimble Glass Co. v. Comm’r, 9 T.C. 183 (1947): Determining Royalty vs. Sale of Patent for Tax Withholding

    9 T.C. 183 (1947)

    Payments for the exclusive right to make, use, and sell a patented invention constitute the purchase price of the patent (a sale), not royalties from a license, and are thus not subject to tax withholding for nonresident aliens, unless the agreement only transfers some, but not all, of those rights.

    Summary

    Kimble Glass Co. made payments to three nonresident aliens under various contracts related to patents. The IRS determined these payments were royalties subject to withholding tax. Kimble argued the payments were either the purchase price for patents or compensation for services performed outside the U.S., neither of which are subject to withholding. The Tax Court held that most of the contracts constituted sales of patents, except for one that only transferred some of the patent rights, and thus only payments under that specific contract were subject to withholding.

    Facts

    Kimble Glass Co. contracted with Felix Meyer, Jakob Dichter, and Pierre A. Favre, all nonresident aliens, for rights related to glass manufacturing patents. The contracts involved fixed payments and payments based on production or sales. The specific terms varied, including assignments of patents and exclusive licenses to make, use, and sell inventions. Kimble initially did not withhold taxes on these payments, relying later on an attorney’s advice. Some payments were also for services performed by Meyer in Europe.

    Procedural History

    The IRS assessed deficiencies and penalties against Kimble for failing to withhold income taxes on payments made to the nonresident aliens. Kimble petitioned the Tax Court, contesting the deficiencies and claiming overpayment for certain years. Kimble filed delinquent returns for some years after an investigation by the Alien Property Custodian.

    Issue(s)

    1. Whether payments made by Kimble to Meyer, Dichter, and Favre constituted royalties for the use of patents, subject to withholding tax under Section 143(b) of the Internal Revenue Code.
    2. Whether the penalties for failure to file timely returns should be imposed.

    Holding

    1. No, for the Dichter and Favre agreements and the June 2, 1933, Meyer agreement; Yes, for the September 17, 1925, Meyer agreement because those agreements transferred the exclusive rights to make, use, and sell the inventions, constituting a sale of the patent, while the 1925 Meyer agreement was only a license.
    2. Yes, for the payments under the 1925 Meyer contract because Kimble did not demonstrate reasonable cause for failing to file returns before 1936.

    Court’s Reasoning

    The court distinguished between a sale of a patent (transferring all rights to make, use, and vend) and a mere license. Citing Waterman v. Mackenzie, 138 U.S. 252, the court stated that “when the patentee transfers all of these rights exclusively to another…he transfers all that he has by virtue of the patent and the transfer amounts to a sale of the patent. Where he transfers less than all three rights to make, use, and vend for the term of the patent…the transfer is a mere license.” The Dichter and Favre agreements and the June 2, 1933 Meyer agreement granted Kimble the exclusive right to make, use, and sell, thus constituting a sale. The September 17, 1925 Meyer agreement, however, only conveyed the rights to manufacture and sell, not to use, and was deemed a license. The court also noted that the fact percentage payments were included did not negate the sales. The court relied on Commissioner v. Celanese Corporation, 140 Fed. (2d) 339 to reject the argument that periodic payments are subject to withholding if the seller retains an economic interest. Penalties were upheld for pre-1936 failures to file regarding the 1925 Meyer agreement, as Kimble did not demonstrate reasonable cause.

    Practical Implications

    This case clarifies the distinction between a sale of a patent and a mere license for tax withholding purposes. It emphasizes that the substance of the agreement, not its label, controls. Attorneys drafting patent agreements should be aware that transferring all three rights (make, use, and vend) constitutes a sale, exempting payments from withholding tax for nonresident aliens. Retaining even one of these rights suggests a license, which triggers withholding obligations. This case is relevant in structuring international patent transactions to minimize tax burdens. Later cases have cited Kimble Glass for its clear exposition of the Waterman v. Mackenzie rule regarding patent assignments versus licenses.