Division of Tax Appeals Rules Patent License Fees Not Subject to Sales Tax in New York

by McDermott Will & Emery
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A New York State Division of Tax Appeals administrative law judge (ALJ) recently ruled in favor of a medical device and technology company on the question of whether patent license fees that the company charged to its customers were subject to New York sales tax.  In Matter of AMO USA, Inc., DTA No. 824550 (N.Y. Div. Tax App. June 19, 2014), the ALJ determined that the patent license fees were not taxable because they were received in exchange for the right to use the company’s patents, which was a valuable intangible right that could be sold separately from any tangible personal property.

AMO USA, Inc., (AMO) was engaged in the development, manufacture and distribution of surgical procedures and technologies involved in corrective eye surgery.  AMO developed and patented surgical methods that involved the use of lasers, and also developed and patented various types of apparatuses used to perform the surgery.  Under U.S. patent law, the patents issued to AMO covering the methods and apparatuses used to perform laser-assisted surgery created an enforceable right against the unauthorized use of AMO’s methods and apparatuses covered by the patents for a limited period of time.  AMO sold the lasers in New York and always collected sales tax from its purchasers on these sales.  When AMO sold a laser directly to a physician or hospital that would operate the laser in surgical procedures, AMO also granted its consent to perform the surgical procedures covered by its patents by entering into written patent license agreements with the purchasers.  The fee that the customer paid for the right to perform AMO’s patented surgical procedures was separately stated from the charge for the equipment on the customer’s invoice.

New York imposes its sales tax on retail sales of tangible personal property.  “Sale” is defined as “any transfer of title or possession or both ... for a consideration.”  Thus, in order for sales tax to apply, there must be a transfer of title or possession of tangible personal property for a consideration.  Further, under New York law, the primary purpose of the transaction controls the taxability of the entire transaction, even if some parts of the transaction would be taxable and other parts would not be if they were purchased separately.  If a person makes a taxable sale of tangible personal property, the entire amount of the receipt, including any expenses incurred by the seller that are passed on to the purchaser, is subject to sales tax.

The Division of Taxation (Division) asserted that the patent license fees were not independent of the charges for tangible personal property, and thus the entire transaction should have been subject to sales tax.  AMO, however, explained that the patents themselves were valuable, intangible rights that could be sold separately from any tangible personal property.  The ALJ agreed, remarking that the “essential and considerable value of a patent is the intangible right vested in its owner to have exclusive authority and control over the procedure, process or apparatus for a term of years[.]”  The ALJ’s conclusion was supported by the fact that AMO charged different license fees depending on the procedure to be used, and the amount of its license fees were related to the patents covered by the patent license agreements.

In reaching his decision, the ALJ distinguished this case from an Advisory Opinion, TSB-A-11(32)S (Dec. 7, 2011) in which the Division had ruled that certain patent license fees paid in connection with laser eye procedures were subject to sales tax because the fees represented an expense that was passed on from the seller to the buyers.  In the Advisory Opinion, the taxpayer was not the owner of the patents that its customers were licensing, but was itself paying a royalty to the patent owner and passing that royalty expense through to its customers.  The ALJ recognized that the rationale in the Advisory Opinion was not applicable because “[AMO] owned the patents and merely granted a license to its customer.  The intangible right temporarily transferred was not an expense passed through to its customers.”  (Emphasis in original.)

The ALJ also rejected the Division’s attempted application of the step transaction doctrine to characterize the sale as one of tangible personal property.  Although the Division asserted that the reality of the situation was that AMO’s only goal was the sale of the laser system, the ALJ found this argument to be “ill-fitting and tenuous.”  The ALJ also found that, even if the step transaction doctrine were applied, “the individual step of having customers purchase patent licenses was an intended end result in and of itself, i.e., the protection and preservation of a valuable intangible[.]”

The Department of Taxation and Finance has 30 days from the determination date to appeal.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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