If there was any doubt about the value of patents to high-tech companies, Apple Inc.'s recent $1 billion victory over Samsung Electronics erased it.
Now the Internal Revenue Service wants a share of the action. The agency is beefing up staff, both nationally and in the San Francisco Bay Area, to look more closely than ever at how high-tech companies price intellectual property transactions involving their overseas subsidiaries.
And it's cracking down on tech companies in Silicon Valley that it suspects are dodging taxes on the profits their IP generates. Companies, however, aren't opening their wallets. They're fighting back, creating a lot more work for both tax planners and litigators. Tax lawyers say they're trying to help clients stay out of tax trouble, advising them to either work with the IRS before there's a dispute, or make sure they have their facts ready when the tax man arrives.
The IRS has made no secret of the fact that it's increasingly focused on what's called transfer pricing, or how a multinational company allocates income and expenses among itself and its foreign subsidiaries for tax purposes. Companies have long used transfer pricing to shift assets to countries with lower corporate tax rates, such as Ireland.
"There's been a substantial increase in controversy work, not just in Silicon Valley, but nationwide," said Kenneth Clark, who chairs Fenwick & West's tax litigation group and successfully defended Xilinx Inc. in one of the biggest transfer pricing cases in recent years. "We're not only seeing more cases, but also a greater degree of intensity in questioning by the IRS. From the taxpayers' perspective, that can mean a tremendous amount of additional work."
Now in addition to manufactured goods, the IRS is homing in on the transfer pricing of what it calls "intangible" intellectual property. Taxing an intangible asset like a patent, however, is no easy task, lawyers said.
There's much room for subjective interpretation about issues such as a patent's actual market value, and who generates more profit from the patent: the parent company in the U.S. where the idea was patented, or the factory in a foreign country that actually makes the products that the parent company sells?
"You end up having a battle over who is adding value," said John Ryan, a partner at Bingham McCutchen in Palo Alto who focuses on tax planning and audit defense. "And reasonable minds differ."
Several IP-heavy tech companies in Silicon Valley recently disclosed transfer pricing disputes with the IRS in their Securities and Exchange Commission filings, including Hewlett-Packard Co., Adobe Systems Inc., Cadence Design Systems Inc., Juniper Networks Inc. and Yahoo Inc., and the potential liabilities are substantial.
Last year, the IRS told Juniper Networks that it owes nearly $900 million in additional taxes based on cost-sharing arrangements related to the licensing of "intangibles," after auditing the company's 2004 to 2006 tax returns. The Sunnyvale, Calif.-based maker of network infrastructure equipment is fighting the tax bill and said in a recent SEC filing that the IRS' position is "inconsistent with applicable tax laws, judicial precedent and existing Treasury regulations."