Posted by Susan Dierenfeldt-Troy, Esq.
Troy & Schwartz, LLC
Where Legal Meets Entrepreneurship™
Intellectual property assets may comprise as much as 70% of an average company’s value according to the Harvard Business Review. Not surprisingly, businesses large and small are concerned about: 1) protecting their intellectual property from theft or infringement and potential creditors; and 2) reducing their income taxes as part of an overall IP asset management strategy. Intellectual property holding companies (IPHCs) became a popular means through which companies sought to protect their IP assets and reduce taxes by establishing a wholly-owned subsidiary whose purpose was only to control and own IP assets such as patents, copyrights, trademarks, trade secrets, and other proprietary information in the 1990s.
The IPHC, established by the parent company, does not itself use the IP it owns (e.g., by manufacturing and distributing a patented product). Instead, the holding company licenses its IP rights to affiliated operating companies that handle the day-to-day business activities but do not themselves own any of the IP assets. The holding company as the licensor then receives royalties from its licensee(s). For example, say ZYX, Inc. owns a U.S. patent for a product it manufactures and sells under a registered trademark. It has decided to form a Delaware IPHC, CBA, Inc., for holding its patent and registered trademark. CBA, Inc., now as the IPHC, licenses the patent and registered trademark to ZYC, Inc. in return for a two percent royalty on the patented and trademarked product’s sales. For states such as Delaware which does not charge income tax on royalties, the tax savings can be substantial. Additionally, ZYX, Inc. can likely take the royalty payment as a tax expense write-off.
States eventually figured out that holding companies were costing them a lot of money and the majority of them have enacted different types of reporting requirements for IPHCs to recover tax monies: a) mandatory combined reporting (requiring companies to file a single comprehensive tax return for all of their subsidiaries when they calculate their taxes); b) add back statues (requires companies to add back any tax deductions they have taken for royalties paid to their IPHC); and c) the economic nexus approach wherein courts are tasked with finding if an economic nexis (a/k/a/ the Geoffrey rule after a 1993 South Carolina case involving Geoffrey, Inc. as the IHPC for the Toys “R” Us trade name) exists. As such, IPHCs are not used as much as they were over a decade as a tax “shelter.” Delaware, however, still continues to be an IPHC tax haven.
What about Florida? Florida does have a corporate income tax but remains one of a handful of “corporate income” tax states that hasn’t adopted an add-back or combined reporting statute to try and reclaim lost tax revenue attributable to Florida IPHCs. Furthermore, Florida IPHC law is complicated by the fact that only mining companies, by statute, must count royalties when calculating their income taxes. For an excellent discussion on the politics surrounding the issue of Florida IPHC taxation see Florida Tax Laws and Intellectual Property by Jason Garcia, Florida Trend Magazine.
Despite the fewer taxation benefits now afforded by most states to IPHCs, IPHCs can still offer IP asset-protection benefits, for example by allowing a company to quarantine its intellectual property from claims brought against the operating companies. For instance, in the event the affiliated operating company is sued, the separation of IP assets from the affiliate to an IPHC may well protect that property from potential judgments in a lawsuit.
Any business entity, including an IPHC should be structured in a manner that best fits the business model. All business entities, whether a C-Corp, S-Corp, or Limited Liability Company have their own considerations which should be discussed with in attorney knowledgeable in IP asset protection. Any such IP transfer needs to be in writing and is generally executed as an assignment of rights document. The assignment of any issued patent and registered trademarks and copyrights should be recorded with the United States Patent and Trademark Office and/or the U.S. Copyright Office.
Anybody considering forming an IPHC should of course understand the taxation requirements of the state where the IPHC entity will be formed. Additionally, any IPHC owner needs to understand that infringement actions involving the IP owned by an IPHC may result in unintended consequences for the unwary. For example, whether or not a plaintiff has standing to sue is a threshold question in any lawsuit. For a patent infringement action, only patent owners or exclusive licensees have standing to sue for infringement. A typical exclusive licensing agreement may not be “exclusive” for patent infringement purposes. That is, absent a provision within the exclusive licensing agreement that the patent licensee has the right to sue, the exclusive licensee may be found to have no independent right to sue.
Why is this important to an IPHC? Because the IPHC may be able to obtain an injunction as the patent owner, but will be limited in its ability to seek lost profits as damages. For example, a patent-holding IPHC normally does not manufacture or sell a product itself. The IPHC thus suffers no lost profits damages as a result of any infringement of its patent and any recovery will likely be limited to reasonable royalty damages which are generally substantially lower than lost profits. Rite-Hite Corp. v. Kelly Co., 56 F.3d 1538, 1553 (Fed. Cir. 1995).
As for non-exclusive patent licenses, the IPHC cannot claim lost profits and will be limited to an award of reasonable royalty damages. However, non-exclusive patent licenses may provide the IPHC with additional opportunities to exploit its IP beyond just one licensee.
In the context of trademark rights, the IPHC holding company must have sufficient quality control over the goods/services provided under the licensed trademarks. Failure to exercise sufficient quality control may create what is known as “naked licensing”, resulting in potential cancellation of the registered marks. Click here for a previous blog on the ramifications of naked licensing.
Take Home Points:
- Before setting up an IPHC, understand the tax laws of the proposed entity-formation state by consulting with a knowledgeable CPA or tax attorney.
- Before setting up an IPHC, determine the best type of business entity by consulting with a knowledgeable IP asset protection attorney.
- Ensure that the assignment of IP assets to the IPHC is done via a formal assignment agreement.
- Ensure that an exclusive patent licensing agreement includes appropriate provisions giving the exclusive licensee the right to sue for patent infringement. Utilize the services of a knowledgeable IP licensing attorney.
- For trademark licensing, ensure that the licensing agreement includes appropriate provisions allowing the IPHC to monitor the quality and goodwill of the licensed marks. As with patent-licensing agreements, utilize the services of a knowledgeable IP licensing attorney.
THANK YOU FOR YOUR INTEREST IN THIS BLOG. AS USUAL THE CONTENT IS FOR INFORMATIONAL PURPOSES ONLY AND IS NOT LEGAL ADVICE.
Call us for a complimentary consultation on IPHCs or IP-licensing or any of your IP legal needs at 305-279-4740.
May you and your loved ones stay safe & be well during these challenging times.
© 2020 by Troy & Schwartz, LLC
