8170 / What are the tax implications if less than "all substantial rights" to intellectual property are contributed to a corporation?

For years, the IRS asserted that IRC Section 351 nonrecognition treatment with respect to transfers to corporations (and, therefore, Section 721 for transfers to partnerships) did not apply to a transfer of patent (and other intellectual property) rights unless the transaction would rise to the level of a sale or exchange under Section 1001. Thus, the transferor would have to relinquish “all substantial rights” to the patent in order to qualify. According to the IRS, the retention by the transferor of substantial rights in the patent or other intellectual property would constitute a license of intellectual property rights and, therefore, not an exchange of property.¹ The IRS did not treat the transfer of a license as a transfer of “property” under Section 351, because a similar transfer to a third party would not constitute a sale or exchange pursuant to Section 1001 for purposes of realizing gain or loss on the transaction.

The IRS claimed that because the language in Section 1001 is similar to the language in Sections 351 and 721 (i.e., “exchange”), the transfer had to satisfy the same test as under Section 1001—meaning that all substantial rights had to be transferred—in order to qualify for nonrecognition treatment under those two sections.

The IRS asserted its “all substantial rights” argument to the Court of Federal Claims in 1973 and lost.² In that case, Du Pont was engaged in the domestic sale and exportation (to France, among other places) of urea herbicides. Du Pont organized a wholly-owned French subsidiary, Du Pont de Nemours (France) S.A., to manufacture the herbicide in France. Du Pont granted to the subsidiary a royalty-free, non-exclusive license to make, use and sell urea herbicides under the French patents. Du Pont gave up its right to assert patent infringement against the subsidiary’s products for the duration of the license, which was for the remaining life of the patents. The subsidiary had the right to sublicense manufacturing for its own needs, but any other sublicensing could only be done with the parent’s consent. In exchange for this grant, and in lieu of royalties, Du Pont received stock in the subsidiary valued at $411,500.

The Court of Claims found that Section 351 embodies the same notions as the capital gains provisions and found that the purpose of the capital gains provisions is to allow capital gain treatment when a person divests substantially all of its rights in property to a third person, whereas the purpose of Section 351 is to ensure that a transferor avoids immediate taxation when it rearranges its business assets and affairs by contributing certain assets to corporations.³

After finding the capital gains “sale or exchange” provision irrelevant, the Court of Federal Claims had no problem accepting the nonexclusive license as “property” for purposes of Section 351. The Court of Claims found the nonexclusive license constituted “property” for purposes of Section 351 as “one chunk of rights was permanently severed from the main property—the patent.” Thus, the Court of Federal Claims found that the contribution of the license to the corporation should be treated as a nonrecognition event.⁴