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For Richer or Poorer: Intangibles Spawn Deductions

By acquiring the rights to develop and market a product, a struggling company can pick up tax benefits.
Robert Willens, CFO.com | US
April 25, 2011

Embedded in the tax code is the principle that just as companies must pay taxes on their earnings, they also merit tax breaks when they suffer losses. Thus, when a corporation incurs more expenses than revenues, its allowable tax deductions often exceed its taxable income by what's called a net operating loss (NOL). For the struggling companies that often can report them, NOLs can be a very good thing, since they can be used to recover past tax payments or cut future outlays.

In a letter ruling (201106001) issued February 11, the Internal Revenue Service showed how a company with intangible assets can boost the amount of NOLs it can use following an ownership change. The subject, a company we'll call PoorSmart, entered into a sub-license agreement with another company we'll call RichSmart. Under the agreement, RichSmart provided PoorSmart with patents, know-how, and the rights to develop and distribute a certain product worldwide.

PoorSmart agreed to pay RichSmart an initial license fee and was obligated to make future "milestone" payments to the seller of less than a certain amount of dollars in the aggregate, as well as royalty payments.

For tax purposes, PoorSmart capitalized the license fee it later paid. After that, the company applied for regulatory approval to market the product it had obtained the rights to market from RichSmart. After being turned down once, PoorSmart finally got the regulatory approval it had sought.

Since inception, PoorSmart had incurred a certain amount of dollars in NOLs and accumulated a certain amount in research and development credits. PoorSmart had undergone no fewer than four ownership changes.

Later, PoorSmart entered into an amended sub-license agreement with RichSmart. Under the amended agreement, RichSmart made an upfront payment to PoorSmart, and will make future payments totaling a certain amount upon the achievement of milestones, as well as make royalty payments.

In its ruling, the IRS held that the rights to develop and distribute the product worldwide acquired by PoorSmart under the sub-license agreement are intangible assets and are subject to amortization. It also found that if PoorSmart had on the date the assets changed hands a "net unrealized built-in gain" (that is, the aggregate fair-market value of its assets exceeded their aggregate adjusted bases by more than a threshold amount), and a number of other conditions apply, the product rights will generate a "recognized built-in gain." (An RBIG is any gain recognized on the disposition of any asset during the five-year recognition period following the disposition.)

When a corporation with net losses undergoes an "ownership change" within the meaning of the tax code's Section 382(g), limits can be imposed on the amount of taxable income that may be offset by the company's prechange losses. But by being able to book an RBIG, PoorSmart could remove the limit on the NOLs it can use to reduce its taxes, according to the letter ruling. PoorSmart might thus have made itself a little richer by acquiring some of RichSmart's intangible assets.

Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for CFO.com.




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