Guest Post: Transfer Prices Are an Evidentiary Gold Mine for Patent Defendants

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Guest Post by Andrew Blair-Stanek, Assistant Professor of Law at University of Maryland Carey School of Law

Patent owners routinely tell the IRS, under penalties of perjury, that their patents have little value.  Litigators representing defendants should take advantage of these remarkable admissions.

IP has become the world’s leading tax shelter.  Multinational corporations develop IP in the U.S. and promptly transfer it for artificially low prices to subsidiaries in tax havens, where profits from the IP escape tax.  As IP becomes increasingly essential to economic activity, more and more profits have been siphoned off to tax havens.  The low transfer price is crucial to this strategy, minimizing the tax paid in the U.S.  Tax law cannot easily stop this abuse, because of international tax law norms enshrined in bilateral tax treaties.

But this tax avoidance presents great opportunities for litigators representing IP defendants sued by multinationals.  As I discuss in a new UCLA Law Review article, defendants can discover transfer-pricing evidence and use it to argue for invalidity, non-infringement, lower damages, and no injunctions.

For example, a low transfer price for a patent weighs towards lower damages.  Tax law requires multinationals to use a transfer price equal to a patent’s fair market value.  Multinationals must hire appraisers to justify this valuation and then attest that the valuation is accurate under penalties of perjury.  The fair market value of a patent approximately equals the profits or royalties that it is expected to generate, so a low transfer price is an admission by the multinational that it expected low profits or royalties.  Since patent damages are measured by either lost profits or royalties, the low transfer price is evidence weighing towards lower damages.

As another example, a patent’s low transfer price is nontechnical evidence – akin to the existing secondary considerations – that the patent is invalid for obviousness.  Obviousness is measured by reference to a person having ordinary skill in the art before the patent application’s filing date.  To minimize taxes, multinationals typically transfer patent rights as soon as possible, often around the same time the patent application is filed.  A multinational is ideally situated to evaluate how substantial the advance was, because it employs the inventors, who have ordinary or above-ordinary skill in the art.  In short, low transfer prices are admissions, at the relevant time, by an ideally-situated party, that the invention was not a substantial advance.

A low transfer price also negates evidence of a patent’s commercial success.  Courts consider commercial success to be evidence of nonobviousness under the reasoning that if the invention had been both obvious and lucrative, then someone would have thought of it earlier.  But this reasoning rests on the implicit assumption that the invention’s potential commercial success was perceived before its development.  A low transfer price refutes this implicit assumption and severs any logical connection between commercial success and nonobviousness.  A low transfer price proves that the multinational perceived little potential commercial success from the invention, even after its development.

Low transfer prices can also help defendants fight injunctions, which require the patentee to demonstrate that it faces irreparable injury that cannot be compensated by damages.  But a patent’s value roughly correlates with the maximum damages for infringing it.  A low transfer price for a patent demonstrates that harm from infringement can be quantified and, indeed, was quantified at a low number.

The transfer prices themselves are only half of the evidentiary gold mine.  IRS regulations require that multinationals hire appraisers to prepare rigorous documentation justifying the low transfer prices as accurate valuations.  This documentation typically makes as strong a case as possible that the patents have little profit or royalty potential.  Sometimes the documentation even contains damaging opinions or facts about the patent’s validity or scope.

My article’s arguments do not impact patents transferred between unrelated parties, such as an individual inventor selling a patent to a manufacturer.  When unrelated parties sell or license patents, the prices can reflect any number of distortions ranging from information asymmetries to differences in bargaining power.  None of these distortions exist when a multinational transfers a patent to its own tax-haven subsidiary.

Individual inventors, start-ups, and other small businesses cannot avoid taxes by transferring their IP to tax-haven subsidiaries.  Multinationals can.  This advantage distorts the employment market for scientists and engineers, making them more likely to work for multinationals.  This distortion likely reduces the overall progress of the useful arts, given the higher research productivity of start-ups and other small firms.  By making the arguments discussed in the article, litigators representing patent defendants can not only serve their clients’ interests, but also reduce this distortion.

In sum, during discovery, patent defendants should request transfer prices and the supporting appraisal documentation.

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36 thoughts on “Guest Post: Transfer Prices Are an Evidentiary Gold Mine for Patent Defendants”

  1. 19

    A major issue is that in just a few years: a patent’s value can change by greater than 100 times.

    For example,
    The Bell telephone patent (from $100k to $25M).
    Early Google, when the Google guys wanted $1M for Google, so they would then have the time to focus on their Phd’s.

  10. 10

    This is the flip side of the anti-npe defense argument of “but you only paid 100k for the patent and now you want 10M from us?”

    Doesn’t really work in the npe context and won’t work in here either.

    1. 10.1

      When an NPE buys a valuable patent for $100k, the low price will often be due to information asymmetry and the NPE’s superior bargaining power. By contrast, when a multinational transfers a patent to its own subsidiary, there is no information asymmetry and no bargaining — making the price much more relevant than in the NPE situation. (See section III.F of the article.)

  11. 9

    This is a disastrous article, in any time.

    I won’t sugar-coat it: this article is so unfortunate, that it’s not worth discussing meaningfully.

    Reducing it to one line would achieve a superior result: during litigation, consider transfer price evidence. The rest is, well…

  12. 8

    This is an excellent and timely article. The New York Times is in the midst of publishing a series of articles dealing with the use of shell corporations by foreign companies and entities.

    link to nytimes.com

    Vast sums are flowing unchecked around the world as never before — whether motivated by corruption, tax avoidance or investment strategy, and enabled by an ever-more-borderless economy and a proliferation of ways to move and hide assets.

    The Times examination reveals the workings of an opaque economy for this global wealth. Lacking incentive or legal obligation to identify the sources of money, an entire chain of people involved in high-end real estate sales — lawyers, accountants, title brokers, escrow agents, real estate agents, condo boards and building workers — often operate with blinders on.

    As an indication of how well-cloaked shell company ownership is, it took The Times more than a year to unravel the ownership of shell companies with condos in the Time Warner Center, by searching business and court records from more than 20 countries, interviewing dozens of people with close knowledge of the complex, examining hundreds of property records and connecting the dots from lawyers or relatives named on deeds to the actual buyers.

    Yet in some cases it is nearly impossible to establish with certainty the source of money behind shell companies. Purchasers can register shell companies in the names of accountants, lawyers or relatives. Purchases are often made not just by individuals but on behalf of groups of investors or numerous family members, further obscuring the origin of the funds. What is more, ownership of shell companies can be shifted at any time, with no indication in property records.

    No doubt the rise in shell company ownership of patents parallels the patent explosion generally. Oppen the doors to the lowest form of innovation and (surprise!) the lowest form of innovators immediately rushes in. Nobody could have predicted ….

    1. 8.1

      “No doubt…”

      Because “money” is bad. Or something.

      (you really need to get into a different line of work Malcolm)

        1. 8.1.2.1

          What’s with the Royal “we,” Mr. Internet Toughguy?

          You’ve got a philosophical beef with software patents. I get that. But your nigh constant denigration of the profession in pursuit of your agenda to totally discredit the leading area of innovation today is simply beyond the pale. No one (outside the lemmings) cares that you feel that that type of innovation is the “lowest” form. It just does not matter because that “lowest” form is still protected by the law – the controlling law that you are not at liberty (if you truly are an attorney) to dissemble about.

    2. 8.2

      “No doubt the rise in shell company ownership of patents parallels the patent explosion generally.”

      If it is merely parallel, then it is not a driver and you are barking up the wrong tree.

      Reminds me of the independent objective government body study that debunked the “Tr011” witch hint and “explosion” of litigation…

      Hmm, Malcolm’s dichotomy resurfaces, with him feeding the “Tr011” myth that Big Corp started (while appearing to be against 1%’s, he again is a foot soldier for their cause)…

  14. 6

    The mystery is why the IRS itself is not challenging either deflated value or inflated value IP transfers allowing many billions of dollars in income tax avoidance.
    Of course there is a big difference between transferred trademark rights or copyrights and transferred patent rights.

    1. 6.1

      Income Tax avoidance?

      Property Tax perhaps… But I think low balling the value of a patent would INCREASE the INCOME tax paid if it were eventually sold as it would tend to increase the capital gain involved.

      Would it not?

      1. 6.1.1

        Under the current discussion, the patent was transferred to a non-US affiliate of the originator corp.

        If that non-US affiliate has no business in the US, then when it transfers the patent again (at a higher price per your question), US tax wouldn’t be implicated.

  15. 5

    This argument seems not to consider the “option” issue that if a patent application is transferred soon after filing, there are many things that may or may not happen in the market and with the patent application itself that will fundamentally affect the value of any patent that might grant.

    Especially after going through the “arbitrary and capricious” process known as examination before the USPTO…

    But, I suppose that it does give some fodder for cross examination or deposition to counter the lofty rhetoric.

  16. 4

    ” A multinational is ideally situated to evaluate how substantial the advance was, because it employs the inventors, who have ordinary or above-ordinary skill in the art. In short, low transfer prices are admissions, at the relevant time, by an ideally-situated party, that the invention was not a substantial advance.”

    If that’s true, then surely the $1 or maybe $500 that the corporate inventor is given as compensation when he or she transverse title to the corporation by signing an assignment document is also such an admission.

    1. 4.1

      An interesting point Les, but one that shares the same flaw that the authors commit: misjudging exactly who is the owner at the given “price tender.”

      One needs to remember that the price reflects a value at the moment between a given seller and a given buyer. That price is just NOT reflective of what the buyer can then turn around and demand. The reasoning that is implicitly assumed is that there is – and can be – NO markup. That’s just not reality.

      Has no one heard of the phrase “Buy low, sell high”….?

        1. 4.1.1.1

          Oh I definitely appreciated the point you attempted to make Les, my counter though is that your point does not reach (and that the author makes a similar error) for the reasons given.

            2. 4.1.1.1.2.2

              LOL – thanks Les, I don’t watch that show and the point I was making then skips the sarcasm of your post and applies then to the authors here (without sarcasm).

  18. 2

    Excellent perspective (even if as flawed as Mr. Boundy points out).

    Soooo,

    We have court procedures (and costs) separable from patent law.

    We have business formation and asset disclosure law separable from patent law.

    And we now can add that we have tax law that is separable from patent law (what other assets are also caught up in the ‘shell’ game, and why do we permit the shells to exist in the first place?).

    How much “correction” belongs in the patent “ecosystem” when we have the Court oft reminding us that patents should not be the focus of special treatment? Or is it somehow “OK” to have special treatment when degrading patent rights, but not have special treatment that would augment those rights?

    Methinks that some basic assumptions need to be questioned…

  19. 1

    There are two flaws in the argument.

    A patent only has value to the extent that a competitor infringes–or would like to infringe. Most patents just sit in a desk drawer, and thus have low value. But by the time you get to damages phase of an infringement action, the law requires that the calculation start with the assumption that the patent is valid and infringed. This flaw is essentially the same as a statistical argument that asks the reader to assume only ex ante information and ignore ex post information–the analytical reasoning tools no longer apply.

    Second, we already have multiple accounting systems — Generally Accepted Accounting Principles for financial reporting, tax accounting for tax. They’re significantly different. They two systems are designed to get at different information. Damages accounting is a third accounting system. Trying to shoehorn tax round peg into a damages round hole is simply a poor fit.

    1. 1.1

      And a third flaw —

      Taxable transfers are most frequent at the beginning of a patent’s life. The assumption for damages is that the Georgia-Pacific negotiation occurred at the time infringement began.

      Tax transfer pricing is based on actual cash flows that have occurred as of the time of the transfer (I think — I don’t know for sure, but most tax issues are based on cash-based accounting principles). Damages are based on cash flows that will occur after infringement begins.

      Is transfer pricing evidence? Yes. Evidence of damages that will survive Daubert?

    2. 1.2

      Mr. Boundy,

      You smartly point out the difference between GAAP and tax accounting.

      With that in mind, would you share your opinion (generally, of course) on a somewhat related aspect of portfolio valuation (on the books as it were per GAAP) of an entity’s IP assests and the possible devaluation effect of a Supreme Court decision that – on the surface – wiped out the value of that portfolio?

      I have seen discussion where I think “too clever by half” type of reasoning has been used as an excuse for corporations to pretend that there has been no change in value, as well as distinctions made (unsupportable in my view) as to treatment of IP purchased versus IP self generated.

      Are shareholders not being told what they need to be told?

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